One of the best ways to save for college is through what's known as a 529 plan. They're run by the states and soon, all 50 will be offering them.
You get splendid tax breaks from 529s. But some parents and grandparents worry that using these plans will reduce their eligibility for student aid.
It might -- but then again, it might not. You don't know in advance what your particular situation will be. Here are some facts that can help you decide.
The 529 plans come in two forms:
l Prepaid tuition plans -- the conservative choice. These plans guarantee that the money you save today will match the growth in tuition inflation at state-run colleges. Currently, that gives you an average 4.4 percent return. In most cases, you can also use the money out-of-state.
Prepaid plans appeal especially to people with modest incomes who are aiming for a state college or university.
l College-savings plans -- the more aggressive choice. You contribute to a pool of money that's managed by the state treasurer or an outside investment adviser; the 529 created by state of Kansas and American Century investments is called Learning Quest.
A typical savings plan leans toward stocks when the child is young, then moves toward bonds and cash as college draws near. A few plans offer all-stock or all-bond accounts.
You can use the money at any accredited school, for tuition, room, board, books and supplies. If your state's plan is inferior or doesn't disclose performance and fees, you can invest in another state.
Securing tax breaks
Both types of 529s offer tax breaks. All gains are tax-deferred, then taxed in the student's bracket when the money is withdrawn for college bills. Some states let you deduct part or all of your 529 contribution on your state tax return. A few even let the gains pass state-tax free.
These 529 plans help with estate taxes, too -- grandparents, take note. For example, the contribution won't be included in your estate even when your name is on the account.
There's a big difference in the plans, however, for people who qualify for student aid.
In a prepaid plan, every dollar you use for tuition takes a dollar away from your eligibility for aid. Potentially, that means smaller work/study grants, smaller subsidized student loans and less money from funds the schools themselves award.
In a college-savings plan, only a portion of your savings is counted toward your eligibility for aid. When the plan is in a parent's name, the college will count no more than 5.6 percent of the money each year. So you potentially qualify for more aid than you would in a prepaid plan.
If the college-savings plan is in the child's name, the school might want 25 percent or 35 percent of the money annually. So for families that expect aid, it's usually better to keep the savings in a parent's name.
Plans in grandparents' names are another story. When the plans are discovered, some schools assess them at up to 35 percent. Others might use them to reduce aid dollar-for-dollar.
A 529 plan may enter the aid calculation in another form.
When the student takes money out of the plan, the gains are taxed as ordinary income (presumably at a low 15 percent). If the school counts that income in the student-aid formula, your award could shrink by quite a bit, says K.C. Dempster of College Money in Marlton, N.J.
Many schools won't count income from 529s, however, if you point it out. So be sure to do so.
Bottom line, is it worth having a 529 plan?
Definitely yes, if you probably won't qualify for student aid, says savings-plan expert Joseph Hurley in Pittsford, N.Y. For details on all the state plans, see his Web site, www.savingforcollege.com. The plans also make sense for people who want to minimize future student loans.
But skip a 529 if you're willing to gamble that you'll qualify for aid, says Rick Darvis of College Funding Inc., in Plentywood, Mont.
You can't predict your future income so go by whether you'd qualify today. With $70,000 in earnings, you could expect aid (including loans) from an expensive private college but probably not from a state school.
Your income probably will rise in the years ahead but so will college costs, so your eligibility for aid may not change.
The best alternative to a 529 would be a simple mutual fund held in your name -- say, an index fund or tax-managed fund that didn't throw off a lot of taxable gains.
In any case, save, so you won't be at the mercy of college aid. Your reward for saving is taking fewer student loans.