Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Investing for college

Dear Dr. Don,
I have $10,000 to invest toward my daughter's college education in four years. How should I invest this money?
Quadrangle Queen

Dear Quad Queen,
The Economic Growth and Tax Relief Reconciliation Act of 2001 (the Bush tax bill) has given you more college-savings options than you can shake a stick at.

The Education IRA has been renamed the Coverdell Education Savings Account, and CESA contribution limits were increased to $2,000 in 2002. Qualified distributions out of a Section 529 College Savings Plan are free of federal taxation.

The Savings Bonds for Education plan lets you buy savings bonds in your name and not pay federal income taxes on the interest income when the bonds are redeemed for qualified education expenses. (Savings bonds are exempt from state and local income taxes.) There are some income limitations on your ability to participate in the savings-bond program, as there are with CESAs.

Since 2002, you can contribute to both a Section 529 Plan and an Education IRA plan, but total contributions to a CESA from all sources for a named beneficiary can't exceed $2,000.

Section 529 plans include both state prepaid tuition plans and college savings accounts. College savings accounts aren't as limiting as the prepaid tuition plans in selecting out-of-state schools, but the prepaid tuition plans in some states have made strides in making the plans more portable.

There is more investment flexibility with a CESA account but more financial planning options and control available in a Section 529 account. For example, you could open a brokerage account and trade stocks in a CESA.

You won't have that capability in a Section 529 account, but the IRS has recently improved the flexibility of how Section 529 Accounts are invested by ruling that an account could be rolled to another account once each calendar year, very much like an IRA rollover. With $10,000 to invest, you could split the baby and put $2,000 to work next year in a CESA account and $8,000 to work this year in a Section 529 account.

SavingforCollege.com rates the state plans from one to five mortarboards and has separate ratings for out-of-state residents. Investing in your home state's plans may give you a tax break, so start by looking at your state plan. And remember that not all state plans are created equal. If you're not happy with the options in your state's plan, then it's time to go shopping!

Brokerage firms can offer you Section 529 programs from the states where they are named to manage plan investments, so you can talk to your broker about what plans they offer. It will be easier for most people to compare state plans by using a Section 529 Evaluator like the one on SavingforCollege and contacting the state you select for enrollment information.

With only four years until your daughter expects to start college, it makes sense to invest fairly conservatively. At this point you should be more worried about tax consequences and protecting principal than looking for high investment returns. It's also important to consider how this money will impact your daughter's ability to qualify for various financial-aid packages.

-- Updated: Oct. 19, 2006