STATE SAVINGS PLANS
Since Kentucky pioneered the concept in 1990, parents have poured more than $4.2 billion into various state-sponsored college-savings plans. And it's easy to see the appeal: The plans combine tax-deferred growth with the ability to earn stock-market returns on your savings.
The state invests the money on your behalf in a combination of stocks, bonds, and cash; the precise mix depends on your child's age (the plans invest more aggressively for growth when your child is younger, then gradually move to more conservative holdings as the college years get closer) and the program manager's investment philosophy. While the account is building, you don't pay any taxes on the earnings; some plans also allow parents who live in-state to deduct their contributions on their state tax return. When money is withdrawn from the account to pay for college (in any state, not just the one sponsoring the plan), the earnings will be taxed by the federal government at the child's, or student's, rate, allowing more of the money to be used for tuition, not taxes. In most plans, residents don't have to pay any state income taxes on those withdrawals.
So why shouldn't you rush out today to sign on the dotted line? "These plans haven't been around long enough to judge their real track record," says Ray Loewe, president of College Money, a Marlton, NJ-based financial-planning firm. One area of concern is the impact they may have on a child's ability to qualify for financial aid: If the plan is in a parent's name the Department of Education will not count it in financial-aid formulas, but each college's rules may vary. Many advisers also balk at the restrictions put on parents. You have no say in how your savings are invested once you've enrolled in a particular plan, and you can't use the money for any purpose other than higher education for your immediate family without paying a hefty penalty.
For whom does this type of plan work best? In general, notes Bernie Kent, a tax partner at PricewaterhouseCoopers, in Detroit, "it's more attractive the younger your child is and the higher your tax bracket, since you'll benefit more from tax-deferred growth."
PREPAID TUITION PLANS
On the surface, these plans offer what seems to be an unbeatable deal: tomorrow's tuition at today's prices. Now offered by 19 states, the plans allow parents to pay current tuition rates for public colleges and universities within the state issuing the plan -- either in a lump sum or installments -- with a guarantee that the amount paid will cover future tuition costs at any of those institutions.
But what may have represented a bargain several years ago, when tuitions were rising at annual rates as high as 10 to 12 percent, seems less enticing now that college inflation has slowed to 4 to 5 percent a year.
Though experts are quick to point out that rates could certainly rise again, for many financial advisers, the more serious drawback to prepaid plans is the impact on financial aid. "For any child with even half a prayer of qualifying for assistance, the prepaid plans are a disaster," says Kalman Chany, author of Paying for College: Without Going Broke. According to current rules, you lose one dollar of financial aid for every dollar you withdraw from a prepaid plan to pay for college.
And since plan sponsors only guarantee full tuition payment if your child attends a school in the issuing state, you'll have to make up the price difference if your child attends a more expensive out-of-state school.
THE EDUCATION IRA
Introduced recently, the Education IRA does for college what the Roth IRA does for retirement: provide tax-free growth for your savings, and tax-free withdrawals when the time comes for you to use the money. As with the Roth IRA, contributions to an Education IRA are not deductible on your federal income taxes in the year you make them; the payoff comes at the end, when you're ready to withdraw the money and you don't owe a dime to Uncle Sam. Moreover, you're free to invest the money in your child's Education IRA any way that you like.
The catch? The maximum you're allowed to contribute annually to an Education IRA is $500. A family that invests the maximum every year and earns an average of 8 percent annually on the account would have only $22,000 after 18 years. That's barely enough to cover the estimated cost of one year's tuition at a public college in 2017, and little enough that many financial-services companies don't even bother to offer these IRAs.
Of course, if you can save only $500 a year for college anyway, you might as well put the money into an Education IRA, and at least reap the benefits of tax-free growth (and withdrawal). Indeed, when it comes to socking away money for college, doing something is always better than doing nothing -- and the sooner you do it, the better off your child will be. "Starting early is more important than what kind of investment plan you choose," says Kent. "With time on your side, it's hard to go wrong."
Contributing editor Diane Harris is coauthor of It Takes Money, Honey, a book on personal finance for women.