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College savings plans

Dr. Don Taylor Dear Dr. Don,
My kids are an infant and 3 years of age. What is the best way to save for their college? I currently have a savings account for my 3 year old, but I feel that I could do better.
Thank you,
Oscar Optimal

Dear Oscar,
You can do better.

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Increases in college tuition routinely outstrip increase in inflation. A savings account will struggle to keep pace with inflation and isn't a very attractive investment vehicle for your children's college fund.

Think about more than just setting money aside. Think about how the investment returns are taxed, how investment returns have to outpace rising costs to see an increase in your purchasing power, the annual expenses of investing in different plans and how different plans will influence your child's ability to qualify for financial aid.

The big four in college savings are: prepaid tuition plans, college savings plans, Coverdell Education Savings Accounts and Savings Bonds for Education.

Section 529 Qualified Savings Plans include prepaid tuition plans and college savings plans. Prepaid tuition plans can guarantee that your investment will cover tuition costs at schools covered by the plan. These plans are typically offered by states with the state guaranteeing tuition money equivalent to the cost of its state schools' tuition. The portability of the tuition money to other schools will vary by program.

Prepaid tuition plans are forced savings in that you have to either deposit enough today to cover the plan cost or arrange a time payment plan. Either way, you're contracting to put enough aside to cover the plan's cost.

In contrast, college savings plans are investment vehicles that don't guarantee that the student will have enough in the account to cover tuition expenses. Distributions out of the account are free of federal income taxation and usually free of state income taxes too.

The difference between the two types of qualified savings plans is similar to the difference between a "defined benefits" and "defined contribution" plans for retirement savings. The prepaid tuition plan has a defined benefit while the college savings plan has defined contributions but its success in meeting your child's college expenses is based on the plan's investment returns. does a great job rating the various Section 529 plans and providing an overview of tax, gift and account control issues for these plans.

Coverdell Education Savings Accounts (CESA's) are what used to be called Education IRA's. You invest with after-tax dollars but qualified distributions are free of federal taxation. Contribution limits were increased to $2,000 per beneficiary in the 2002 tax year. You have a lot more flexibility in how you invest in these accounts. You can open an account with a bank, a brokerage firm or directly with a mutual fund family. Keep an eye on the account's annual expenses since high fees and expenses can really create a drag on the account's returns.

For smaller amounts I like the Savings Bonds for Education approach. The bonds are registered in the parent's name but the income is tax-free when used for qualified college expenses. This keeps the money available to the parents for financial emergencies. There are some income restrictions on who is eligible to use this plan so it's not right for everyone, but that's true for CESA's too.

So much depends on your personal finances, if and where your children decide to go to college and your state's income tax code that I can't give you a definitive answer about which plan to choose. Investing in your children's future, however, will always be a winning proposition. If you look at your options and end up not being able to decide, then consult a tax professional to help you make a decision.

-- Updated: Oct. 20, 2006


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