Ask the Dollar Diva By Dorothy Rosen • Bankrate.com

State tuition programs

Dear Dollar Diva,
What is a qualified state tuition program?

These state-sponsored programs help families save for college, and they're sweeping the country like wildfire. Qualified state tuition programs are governed by the federal Internal Revenue Code 529, which is why they're often referred to as 529 plans. About 40 states offer tuition programs, and just about every other state is expected to follow suit in the near future.

State tuition programs are a response to an outcry from families struggling with the rising cost of higher education and the mountain of debt that students are buried under when they graduate. The Diva believes that saving makes a lot more sense than debt, and she urges you, as a taxpayer, to investigate what your state has to offer.

QSTPs come in two flavors: prepaid tuition plans and savings plans. Here are some things they have in common:

• Contributions to the plans are not tax deductible.
• Thanks to the 2001 Tax Relief Act, earnings are not taxed when the money is withdrawn for qualified higher education costs -- at least through 2010.
• Contributions to the plan are determined by the state, and some are very generous, allowing you to sock away more than $150,000 per child.
• You can start a QSTP as soon as the stork delivers the future graduate.
• There are no income limits; everyone can partake of the feast.
• Contributions are eligible for the gift-tax exclusion.
• Investments are directed by the state, not the account owner, although some states offer minimal choices.
• Withdrawals can be used for any college in the country.
• If the potential graduate decides not to go to college, a new beneficiary can be named on the account.

Prepaid tuition plans

These plans were designed to offer families a hedge against inflation. Generally they work like this: Tuition is set based on the age of the child and current in-state tuition rates, and payments are made upfront or in installments. The child is guaranteed four years of college at a state institution. It works if you hate risk and you're sure your child is going to go to school in state.

One criticism of prepaid tuition plans is that families can do better by investing the money themselves, especially if their future graduate is young and there's a lot of time to build up the college fund. Tuition inflation has been averaging about 6 percent to 8 percent annually during the past 10 years, whereas the S&P 500 enjoyed an annual return of about 18 percent during the same period. Of course, no one knows what the next 10 years will look like.

Another criticism of prepaid tuition plans is the lack of flexibility if a child wants to go to an out-of-state or private school. Funds can be transferred, but if they're based on the tuition for an in-state school and the costs are higher at the school your student chooses, you're going to have to scratch to make up the difference.

Savings plans

Most of the new state-sponsored plans are savings plans. They're like mutual funds where parents or grandparents can invest either a lump sum or make monthly installment payments. Depending on the state, contributions can range from a minimum of $25 a month, to a maximum of more than $150,000.

Many states have turned over the investment management of their 529 plans to reputable investment firms such as Fidelity, TIAA, Merrill Lynch or Vanguard. They may give you a choice between a higher-risk or a lower-risk portfolio, but they won't let you tell them where to put the money. Some plans shift from higher-risk portfolios to lower-risk portfolios as the child gets older.

Every state has its own plan and its own rules. To see what your state is up to, visit the Web site of Joseph F. Hurley, certified public accountant and author of The Best Way to Save for College.

DOROTHY ROSEN has a master's degree in finance, with a specialization in accounting, from the Kellogg Graduate School at Northwestern University in Evanston, Ill. Rosen has more than 15 years of experience in the financial arena, serving in Illinois and Florida as a certified public accountant, financial consultant, expert witness and educator. She is owner of Dorothy Rosen, CPA, a public accounting firm that serves individuals and small businesses.