Saving for College

By Sharon Epperson

Remember this scene? Your eighth-birthday party. Grandma slips you a small package. Your heart sinks: it's not a Walkman. Grandma leans in close. "It's a savings bond," she says with a wink. "It will help put you through college." That's still the way too many people plan to save for a child's education. Nearly all parents know savings bonds, and a lot have heard of education IRAs. But not nearly enough know about what could be one of the best investments for college: 529 plans.

"It's a missed opportunity," says Andrea Feirstein, director of college-savings plans for Salomon Smith Barney. "The 529 plans offer great flexibility and great tax benefits for anyone who has a child in their life, whether it's their child, their grandchild or a godchild."

She's right. Most states sponsor 529 programs that let you either prepay tuition for qualified universities or save funds in tax-deferred accounts for higher-education costs. And you don't necessarily have to live in the state whose plan you choose. Unlike other college-savings plans, 529 programs let you put away huge sums of money--more than $100,000 in some states, vs. the $500 annual contribution for an education IRA--and they generally have no income or age limitations. If you're thinking about going back to school, you can even set up a plan for yourself.

Then there are the tax benefits. Taxes on the earnings in 529 accounts are deferred until the money is withdrawn. When you take out money to pay for college, the earnings are taxed at the student's ordinary income tax rate, which is often lower than the parent's. (If your child skips college, there is a 10% penalty on the earnings.) Another advantage is that the person who sets up the account decides when withdrawals may be made. That differs from a custodial account, whose rules could cause parents to be concerned that their prospective student will use the money for a sporty new car instead of college.

The funds in the account, however, are handled by the plan, not you. Some parents may eschew this cookie-cutter approach to investing. "The downside is, once the money is in the option you choose, it stays there," says Joseph Hurley, a C.P.A. in Pittsford, N.Y., and author of The Best Way to Save for College. Many plans use an age-allocation formula, investing more conservatively as a child gets older. But now that financial-services companies are helping manage these plans, the offerings can be much broader, Hurley says.

Maine, California, Colorado and Illinois allow you to invest entirely in stocks. New York gives residents a tax deduction for up to $5,000 in contributions each year. Louisiana will match some contributions by residents. Hurley offers more details about various plans on his website, www.savingforcollege.com

There are also advantages for estate-planning purposes, says Kathy Boyle, who runs Chapin Hill Advisors in New York City. Your rich aunt can contribute $50,000 at one time and move these assets out of her estate, allowing her to use five years' worth of annual gift-tax exclusions.

So tell your child not to be upset because Grandma gives her a wink and an envelope. If it's invested in a 529 plan, when it's time for college, that envelope will be worth a lot more than a Discman.

Sharon Epperson is a correspondent at CNBC Business News. E-mail her at sharon.epperson@nbc.com