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Saving for college is hard not just because it's a huge expense, but because you can't predict how much, if any, financial aid you'll get.
That's why you need to save what you can now. Fortunately, you have a number of tax-advantaged federal and state college-savings vehicles at your disposal. The best option is the state-sponsored 529 plan, which comes in two flavors: the prepaid tuition plan and the savings plan.
A state's prepaid plan allows you to pay now at today's rates for school tomorrow. In return, your account (or contract as it's often known) is guaranteed to pay for the tuition and fees at the state's public universities and colleges by the time your child graduates from high school. A pre-paid plan often does not, however, cover the costs for room and board.
Your child also may use the pre-paid account to attend a private or out-of-state school but you might risk forfeiting some of its value depending on how the plan values its contracts. Note, too, that most pre-paid plans require that the account owner (you) or the beneficiary (your child) be a resident of the state in which the plan is offered.
The 529 college savings plan, now offered in most states, is far more flexible. The money may be used at any school you choose and for all qualified higher education expenses, including room and board.
Each state determines what the lifetime contribution limit or account balance cap will be in its 529 plan, but typically such limits range between $100,000 and $270,000. Investment minimums are low (most plans let you sock away as little as $25 a month), and there is no restriction on how much you may contribute every year unless the account is nearing the lifetime cap. However, since 529 contributions are treated as gifts subject to gift-tax limitations, if you want to make a tax-free contribution, it shouldn't exceed $12,000 annually ($24,000 if you're contributing with your spouse). Actually, you may contribute as much as $60,000 tax-free in one year ($120,000 with your spouse), but that contribution will be treated as if it were being made in $12,000 installments over the next five years. That means you can't make other tax-free gifts to the beneficiary during that time.
Most 529 savings plans offer a menu of age-based portfolios, and some also offer a small selection of stock and bond funds. In the former case, your annual contributions get invested in a pre-selected portfolio of stocks and bonds. Early on, the portfolio is tilted toward stocks, and as the time for college nears, the weighting shifts more heavily toward bonds. Note, however, that once you choose an investment track, it can be cumbersome to change.
The quality of 529 college savings plans may vary by state, but in most instances you may open an account in any state you'd like.
All 529 plans offer generous tax breaks, provided you use the money for qualified expenses. While your contribution is not deductible on your federal taxes, your investment will grow tax-free and withdrawals will not be subject to federal tax. In prior years your money had grown tax-deferred and earnings withdrawals were taxed at the student's income tax rate. (Note, however, this federal tax-free provision is set to expire in 2010 unless Congress passes a law to extend it.) What's more, you may get state-tax deductions on contributions or exemptions on withdrawals.
One caveat: Having a 529 is likely to reduce your chances of getting financial aid. The 529 college savings account is considered the parent's asset, and hence is assessed at a much lower rate than if it were the child's. Yet withdrawals from a savings plan are considered the child's income, which is assessed at a 50 percent rate for financial aid assessment purposes. A prepaid tuition plan is treated somewhat differently. The amount in benefits paid out essentially reduces dollar-for-dollar the amount assessed as your child's financial need.
Another tax-advantaged option is the Coverdell Education Savings Account (formerly known as the Education IRA). The contribution limit is $2,000 and withdrawals are tax-free. To qualify for a full or partial contribution, your adjusted gross income must be less than $110,000 if you're single; $220,000 if you're married and filing jointly. One of the drawbacks is that the annual contribution cap is per child, meaning if you and your parents want to contribute to an account for your daughter, your combined contributions can't exceed $2,000.
You may contribute to both a 529 and a Coverdell Education Savings Account on behalf of the same beneficiary in the same year without penalty, but your contributions will be treated as gifts subject to gift-tax limitations.