THE BEST WAYS TO SAVE FOR COLLEGE In the college savings game, all strategies aren't created equal. Should you choose a 529 plan, a Coverdell education savings account, or an UGMA/UTMA custodial account in your child's name? Or would you rather put your money in a mutual fund in your own name? Ideally, you'll want to choose a savings vehicle that offers you the best combination of tax advantages, financial aid benefits, and flexibility while meeting your overall investment needs. 529 plans: state savings plans There are two types of 529 plans--state savings plans and prepaid tuition plans. Though each is governed under Section 529 of the Internal Revenue Code (hence the name "529" plans), state savings plans and prepaid tuition plans are very different college savings vehicles. A state savings plan is a tax-advantaged college savings vehicle that lets you save money for college in an individual investment account. Some plans let you enroll directly, while others require that you go through a financial professional. The details of state savings plans vary by state, but the basics are the same: You fill out an application--you are called the account owner or the participant. You name a beneficiary and a successor participant (who would assume control of the account at your death). You also choose one or more of the plan's pre-established investment portfolios for your contributions. Most plans offer a range of investment portfolios that vary in risk. You (or someone else) contribute money to the account as often as you wish, subject to plan limits. Your contributions fund the investment portfolios you've chosen--portfolios typically consist of groups of mutual funds. The financial institution that the state has designated to run its plan is solely responsible for managing the plan's investment portfolios; you have no control over how these portfolios are run. Your contributions grow tax deferred, which means you don't pay income tax on the account's earnings each year. Some states (but not the federal government) may also let you deduct your contributions. Money withdrawn to pay college expenses (a qualified withdrawal) is tax free at the federal level, and may also be tax free at the state level. If the money isn't used for college (a nonqualified withdrawal), you'll owe income tax and a 10 percent federal penalty on the earnings portion of the withdrawal. Anyone can open a state savings plan account--your ability to contribute doesn't depend on your income or your status as a parent. Money in the plan can be used at any college in the United States or abroad that's accredited by the U.S. Department of Education. And, if your child decides not to go to college or gets a scholarship, the account can be transferred to a sibling or other qualified family member without penalty. Plus, if you're unhappy with your plan for any reason, you can switch (rollover) your funds to a different 529 plan (state savings plan or prepaid tuition plan) once every 12 months without penalty. Your state may even offer tax breaks too, like a deduction for contributions or tax-free withdrawals. But state savings plans have drawbacks too. You relinquish some control of your money. Returns aren't guaranteed--you roll the dice with the investment portfolios you've chosen, and your account may gain or lose money. Also, there are fees typically associated with opening and maintaining an account (e.g., an annual maintenance fee, administrative fees, and investment expenses based on a percentage of total account value). 529 plans: prepaid tuition plans Prepaid tuition plans are distant cousins to state savings plans--their federal tax treatment is the same, but just about everything else is different. A prepaid tuition plan is a tax-advantaged college savings vehicle that lets you prepay tuition expenses now for use in the future. Prepaid tuition plans can be run either by states or colleges. For state-run plans, you prepay tuition at one or more state colleges; for college-run plans, you prepay tuition at the participating college(s). Although the details of prepaid tuition plans vary by state, the basics are the same: You fill out an application--you are called the account owner or the participant. You name a beneficiary and a successor participant (who would assume control of the account at your death). You (or someone else) purchase an amount of tuition credits or units in a lump sum or periodically, subject to plan rules and limits. Typically, the tuition credits or units are guaranteed to be worth a certain amount of tuition in the future, no matter how much college costs may increase. Your contributions are pooled together with those of other participants into a general fund, and the money is invested. At a minimum, the plan hopes to earn an annual return equal to the annual rate of college inflation for participating colleges. Your contributions grow tax deferred, which means you don't pay income tax on the account's earnings each year. Some states (but not the federal government) also let you deduct your contributions. Money you withdraw to pay college expenses (a qualified withdrawal) is tax free at the federal level, and may also be tax free at the state level. If the money isn't used for college (a nonqualified withdrawal), you'll owe income tax and a 10 percent federal penalty on the earnings portion of the withdrawal. But prepaid tuition plans have drawbacks too. One major disadvantage is that your child is limited to the participating colleges--if your child attends a different college, plans differ on how much money you'll get back. Also, if the plan earns more than the relevant college inflation rate, you're not necessarily entitled to the difference. Keep in mind, too, that there are fees typically associated with opening and maintaining the account (e.g., an enrollment fee and administrative fees). Finally, money in a prepaid plan is treated less favorably than money in a state savings plan for purposes of federal financial aid (see financial aid section below). Coverdell education savings accounts A Coverdell education savings account (ESA) is a tax-advantaged education savings vehicle that lets you save money for college, as well as for elementary and secondary school (K-12) at public, private, or religious schools. Here's how it works: You fill out an application at a participating financial institution and name a beneficiary. Depending on the institution, there may be fees associated with opening and maintaining the account. Keep in mind that the beneficiary of a Coverdell ESA must be under age 18 when the account is established (unless the beneficiary is a child with special needs). You (or someone else) make contributions to the account, subject to the maximum annual limit of $2,000. This means that the total amount contributed for a particular beneficiary in a given year can't exceed $2,000, even if the money comes from different people. You invest your contributions as you wish (e.g., stocks, bonds, mutual funds, certificates of deposit)--you have sole control over your investments. Contributions to your account grow tax deferred, which means you dont pay income taxes on the account's earnings each year. Money withdrawn to pay college or K-12 expenses (a qualified withdrawal) is tax free at the federal level, and typically at the state level too. If the money isn't used for college or K-12 expenses (a nonqualified withdrawal), you'll owe income tax (at the beneficiary's tax rate) and a 10 percent federal penalty on the earnings portion of the withdrawal. Any funds remaining in a Coverdell ESA must be distributed to the beneficiary when he or she reaches age 30 (unless the beneficiary is a person with special needs). Unfortunately, not everyone can open a Coverdell ESA--your ability to contribute depends on your income. To make a full contribution, single filers must have a modified adjusted gross income (MAGI) of $95,000 or less, and joint filers must have a MAGI of $190,000 or less. Custodial accounts Available even before the creation of 529 plans and Coverdell ESAs were custodial accounts. A custodial account allows your child to hold assets that he or she ordinarily wouldn't be allowed to hold in his or her own name. The assets can then be used to pay for college or anything else that benefits your child (e.g., summer camp, braces, hockey lessons, a computer). Here's how a custodial account works: You fill out an application at a participating financial institution and name a beneficiary. Depending on the institution, there may be fees associated with opening and maintaining the account. You also designate a custodian to manage and invest the accounts assets. The custodian can be you, a friend, a relative, or a financial institution. Keep in mind, though, that if a parent serves as custodian, the entire value of the account will be included in the parent's gross estate if the parent dies while serving as custodian. You (or someone else) contribute assets to the account. Whether your state has enacted the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA) will determine the type of assets you are allowed to contribute (the UTMA allows more types of property than the UGMA, and most states have enacted the UTMA). The account earnings are taxed every year at your child's tax rate. Assuming your child is in a lower tax bracket than you, you'll reap greater tax savings than if you had held the assets in your name. The opportunity for the greatest tax savings occurs once your child reaches age 14. However, while your child is under age 14, the kiddie tax rules apply, which means that any income over a certain threshold ($1,600 for 2004) is taxed at your rate, not your child's rate. Despite the potential tax savings, custodial accounts have a serious drawback: all gifts to a custodial account are irrevocable. When your child reaches the age of majority (as defined by state law, typically 18 or 21), the account terminates and your child receives the money free and clear of parental influence. Some children may not be able to handle this responsibility, or might decide not to spend the money for college. Financial aid impact Your college saving decisions impact the financial aid process. Come financial aid time, your family's income and assets are run through a formula at both the federal level and the college (institutional) level to determine how much money your family should be expected to contribute to college costs before you receive any financial aid. This number is referred to as the expected family contribution, or EFC. In the federal calculation, your child's assets are treated differently than your assets. Your child must contribute 35 percent of his or her assets each year, while you must contribute 5.6 percent of your assets. For example, $10,000 in your child's bank account would equal an expected contribution of $3,500 from your child ($10,000 x .35), but the same $10,000 in your bank account would equal an expected $560 contribution from you ($10,000 x .056). An UGMA/UTMA custodial account is classified as a student asset. By contrast, Coverdell ESAs and 529 state savings plans are considered parental assets if the parent is the account owner (so accounts owned by grandparents or other relatives or friends don't count at all). And distributions (withdrawals) from Coverdell ESAs and state savings plans that are used to pay the beneficiary's qualified education expenses are not classified as parent or student income on the federal government's aid form, which means that some or all of the money is not counted again when it's withdrawn. Other investments you may own in your name, such as mutual funds, stocks, U.S. savings bonds (e.g., Series EE and Series I), certificates of deposit, and real estate, are also classified as parental assets. However, the federal government treats prepaid tuition plans more harshly for aid purposes than state savings plans. A prepaid tuition plan isn't classified as an asset of either parent or student on the aid application. But withdrawals are counted. Specifically, any distributions (withdrawals) from a prepaid tuition plan reduce your child's cost of attendance. The result is a reduction in your child's financial need--and thus financial aid--on a dollar-for-dollar basis. In other words, every dollar that comes out of your prepaid tuition plan will reduce your child's potential aid award by one dollar. (Most colleges treat state savings plans and prepaid tuition plans as parental assets--if the parent is the account owner--and withdrawals as student income.) Legislative sunsets The provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 that made qualified withdrawals from 529 plans tax free at the federal level, as well as the provisions that increased the annual contribution limit for Coverdell ESAs to $2,000, are scheduled to expire on December 31, 2010. Unless Congress acts, after this date, the federal treatment of 529 plans and Coverdell ESAs will revert to their status prior to January 1, 2002 (the earnings portion of qualified 529 plan withdrawals will be taxed at the beneficiary's tax rate, and the annual contribution limit for Coverdell ESAs will be $500).