The financial aid picture for the 2005-06 school year isn’t pretty. More families will have to pony up extra money to put their kids through college during the next school year, according to a recent New York Times analysis. The reason: Changes were made in the federal financial aid formula that requires a greater proportion of family income and assets to be counted toward college expenses.

“As a consequence, tens of thousands of low-income students will no longer be eligible for federal grants,” The Times’ Greg Winter reported in early June. While the changes don’t affect all students across the country the same way, they are expected to have the most impact on middle-class families.

Since free or cheap money is getting harder to obtain, it falls on parents to prepare for their kids’ college education if they possibly can. But it’s hard to save for college while the kids are growing up. As parents, you have competing demands on your income, such as mortgage payments, retirement-plan funding objectives and everyday living expenses.

But if money is allocated toward college savings as an additional “mandatory” expense, a lot can be accomplished using one of many available investment vehicles. These are among the most popular, with pros and cons of each:

Taxable brokerage account — Obviously, you get no tax-deferral benefits by allocating college funds to a regular brokerage account, but if you choose tax-efficient funds or buy stocks and hang on for the long term, you can minimize the tax consequences. Recent changes in the code reduce the tax bite on
dividends and long-term capital gains to 15 percent at most, making regular brokerage accounts a more attractive place to stash funds than in years past.

These will be considered parental assets in the federal formula that determines the expected family contribution to college costs. That’s a good thing, because a much greater share of students’ assets are counted in the federal formula. Only 5.65 percent of parental assets are counted, versus 35 percent of children’s assets, according to Kalman Chany, author of “Paying for College Without Going Broke.” Meanwhile, parental income is assessed at up to 47 percent versus 50 percent for student income.

  • Negative: You don’t get the magic of compound interest working for you as you would in a tax-deferred account.
  • Positive: You have a wide spectrum of investments to choose from. Also, these assets can be used for any purpose, so if your kid gets a free ride through school thanks to academic or athletic achievements, you can target the funds for a completely different goal.

UTMAs and UGMAs — That’s short for Uniform Transfer to Minors Act and Uniform Gift to Minors Act. Once upon a time, these custodial accounts were the happening investment vehicles. Today they are less attractive than other college-savings vehicles that have sprung up in recent years. They’re mini-tax havens because the first $800 in investment income is not taxed at all. If your child is more than 14, any income above $800 is taxed at his or her rate. But if your child is less than 14, the
kiddie tax kicks in.

  • Negative: Assets are in your child’s name, which means two things can go wrong. When the student reaches the age of majority, the money can be spent for anything ( a brand new Honda Element, for instance). Even if it’s kept for college expenses, the money is considered as “student assets” and subject to the 35-percent factor. Of course, if you’re not likely to be eligible for need-based financial aid, this doesn’t really matter.
  • Positive: Parents can transfer appreciated stock into these accounts to avoid paying taxes immediately. The capital gains tax rate for those in the lowest tax brackets (kids generally qualify) is temporarily reduced to 5 percent through 2007. In 2008, they get a capital-gains tax holiday, paying nothing. In 2009, it reverts to the previous capital gains rates. Also, because these custodial assets are shielded from creditors, parents in professions vulnerable to lawsuits (doctors, for example) sometimes use them to protect assets.

Coverdell education savings accounts
— You can open an account at most banks, brokerages and mutual fund firms. These are more flexible than 529 plans (described below) in some respects. They can be used to pay education expenses for private schools at the elementary and high school levels, and can be tapped to pay for books, computers and school supplies.

  • Negative: Annual contribution amount is limited to $2,000 (an improvement over the previous $500 limit, but not a lot nonetheless). Also, married couples making more than $220,000, and single parents making more than $110,000, cannot contribute to these vehicles.
  • Positive: The Department of Education recently ruled that Coverdell accounts are considered parental assets, a big plus for federal financial aid formula purposes. Also, you have a broader selection of investment options from which to choose than with other plans.

529 prepaid tuition plans
— These are the 1980s forerunners of the 529 savings plans. The tuition plans lock in tomorrow’s tuition costs at today’s prices. That’s a meaningful benefit, considering that tuition costs have been escalating at more than twice the annual inflation rate in recent years. Most plans allow you to make lump-sum or installment payments. Not all states offer them and some have discontinued new enrollments. Most are state-specific and impose residency requirements. However, a consortium of 250 private colleges, including Princeton, Stanford and Vanderbilt universities, recently introduced the ”
Independent 529 plan,” which enables you to buy tuition in advance at discounted rates.

  • Negative: If you purchased a particular state’s prepaid tuition plan and your child wants to go to a private or out-of-state school, you can use the credits, but will have to pay any difference in tuition. Conversely, if your child isn’t accepted into the state’s public university system, you can transfer the funds to another family member or into a 529 savings plan, or in some cases use credits to pay tuition at a community college. Also, be aware that these plans pay for tuition, not room and board or other college fees. And, when redeemed, they reduce financial-aid eligibility dollar for dollar.
  • Positive: Since 2002, federal income taxes have been lifted on the difference between the initial investment amount and the value of the credits at redemption. State taxes may apply.

529 savings plans
– Since 529 plans have been introduced in the mid-1990s, they have amassed more than $55 billion in assets. You can sock away big bucks in these plans — as much as a quarter-million dollars — making these the investment vehicle of choice, especially among the wealthy since no income restrictions are imposed. You can also make larger-than usual gifts in these accounts. For example, grandparents with estate-planning challenges can shed assets by gifting $55,000 to each grandchild’s 529 plan, taking advantage of five years’ worth of annual gift exclusions all at one time (though they can’t make any more gifts to the same children for five years).

  • Negative: 529 plans have been
    plagued with problems, most notably inconsistent fee disclosure. The state plans are voluntarily beefing up their fee-disclosure efforts this year, so transparency should improve before 2006. Go to
    www.savingforcollege.com to check out plans with low expenses. Also, only cash contributions are allowed (you can’t transfer stock into a 529 plan), and investment options are limited to the few funds available in a plan.
  • Positive: The funds in 529 plans grow tax-deferred, and are not taxed at the federal level when withdrawn for qualified education expenses. (State taxes may apply if you invest in an out-of-state 529 plan.) As long as parents own them, 529 plans are considered a parental asset for financial-aid purposes — an advantage. Withdrawals are not considered income for either the parent or student, so they have no adverse effect on financial-aid eligibility calculations. You can transfer the plan to benefit a different family member if Junior decides he’d rather be a car mechanic.

The tax-favorable provisions for 529 savings and Coverdell education savings accounts are scheduled to sunset in 2010, but both houses of Congress recently introduced bills to make these plans permanently tax-free. It’s not official yet, but most prognosticators expect legislators on both sides of the aisle to act beneficently. An educated workforce, after all, is in our country’s best interests, and lawmakers are quite mindful of that.