College savings options: The basics

  @Money January 14, 2013: 5:23 PM ET
NEW YORK (Money Magazine)

Sure, you can sock away money in a piggy bank or savings account and hope for the best. But there are better ways to save for college.

We've listed five popular options that make saving easier by giving you money back on your taxes or offering other benefits. Below, you'll find the basics of each -- pros and cons included.

529: 529s earn their name from the section of the tax code they're in and are legally called "qualified tuition programs."

These savings accounts are like IRAs for college: earnings grow tax-free. And if you spend the profits on federally approved college costs, you can withdraw tax-free as well.

529s aren't without their drawbacks, though. If you use the money for non-approved purposes, earnings will be subject to ordinary income tax plus a 10% penalty.

And financial aid application forms generally ask you about your balances in college savings plans. Your eligibility for need-based aid can be reduced each year by a maximum of 5.64% of your college savings (but typically the ratio is smaller than that).

There are two types of 529s:

College savings plans. These plans allow you to save tax-free for almost all standard college costs, including tuition, books, room, and board.

Your contributions will be invested, so ask about the plan's investment strategy and make sure you're comfortable with its level of risk. Typically, you'll be offered a limited choice of investment options: a few standard stock or bond funds, or "target date" funds managed by professionals who will reallocate your assets to safer bonds as your child's college enrollment date nears.

Although most college savings plans are sponsored by states, you can invest in any state's 529, even if you're not a resident of that state or have a child planning to attend college in that state.

Some state plans (see list of recommended plans) boast particularly low costs, impressive long-term track records, or other attractive features. But it pays to at least check if your state offers a valuable tax break for sticking with an in-state plan (see list of included states).

Prepaid tuition plans. Offered by 19 states and one group of private colleges, these plans allow you to prepay for future tuition -- typically at today's prices.

That's an enticing promise to parents who want to protect themselves against skyrocketing tuition. But take notice: prepaid plans usually only cover tuition, so you'll still have to cover your kid's living costs. And make sure to read the fine print. Find out if the plan guarantees to cover you if the state can't keep up with rising tuition costs -- the reality is that many don't.

States like Texas and Alabama have run into trouble keeping up with tuition increases, and it is not uncommon for prepaid plans to be underfunded. Illinois's prepaid plan reported in June 2011 that it had only 70% of the money it needed to meet its long-term obligations to parents.

In response, many have closed to new investors.

LIFE INSURANCE: You can use "permanent" life insurance -- such as whole or universal life policies -- to build up cash or investment balances that can be used for college, retirement, and more.

One big selling point: most college financial aid applications don't ask you about your life insurance. This means the cash balances you can build up in these policies don't typically affect your eligibility for need-based financial aid. But investments in life insurance also have a few downsides. Typically, a big chunk of your early premiums go toward the life insurance part of your contract, which means your first several years' cash balance will be less than you've contributed.

So if you take money out for college within a few years of your initial investment, you will likely lose money.

ROTH IRA: Many Roth IRA investors don't realize that a quirk in federal law allows you to withdraw your contributions tax-and penalty-free for college expenses.

Earnings are subject to income tax, however. And anyone counting on need-based aid to help pay for college should be careful. Roth IRA balances won't reduce your chances of getting need-based financial aid, but withdrawals are listed as untaxed income on next year's financial aid application and thus could reduce future need-based financial aid eligibility, according to Finaid.org.

COVERDELL ESA: The Coverdell is another tax-favored, education-specific savings vehicle designed to cover education costs. But the amount you're allowed to contribute each year is so low -- just $2,000 -- that you'll have trouble saving enough to cover the cost of college.

NEXT: What's the best way for you to save for college? To top of page



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