Don’t Save for College, Invest

Every year, as high school bands practice “Pomp and Circumstance,” seniors are busy celebrating — or bemoaning — their college admission decisions. Their parents, meanwhile, may have been scratching their heads for years, trying to figure out how they’re going to foot the bill for higher education — with an emphasis on “higher.”

College costs have been steadily rising. According to the College Board, parents who sent their kids to a private college paid almost $24,000 for tuition alone in 2007-08, while those who opted for an in-state public school ponied up more than $6,000. Tack on room, board, and non-tuition fees, and college costs rose to more than $32,000 for private schools and more than $13,000 for public ones.

The upward trajectory isn’t likely to abate, but not to worry: If you have college-bound kids — or grandkids, or nephews and nieces, for that matter — there are investment vehicles that can help them tackle tuition and have bucks left over for room, board, and even the occasional spring-break trip to Florida (bail money, alas, not included).

There are moves you should avoid, too. Let’s review the dos and the don’ts, and we’ll offer you to-the-point advice on how savvy savers — excuse me, savvy investors — should proceed.

Top option: 529 college investment plans

What: A tax-favored investment account specifically designed to help cover college costs.

Eligibility: Anyone can contribute to a 529, and though these plans are generally offered through individual states, you’re under no obligation to stick with your state’s plan.

Benefits: As with other tax-favored accounts such as IRAs and 401(k)s, your investment in a 529 — which will typically offer age-based and fixed-allocation portfolios of mutual funds — grows on a tax-deferred basis. What’s more, if you draw down the account for qualified education expenses (such as tuition, books, and room and board), you won’t pay a dime in taxes on the withdrawals, either. Assuming a 15% rate for long-term capital gains, that benefit — when compared with a plain-vanilla taxable account — could add up to $150 per $1,000 in account earnings withdrawn. Other financial perks may include a state tax break for contributions to the plan and, in a handful of cases, matching funds as well.

Our advice: With the favorable tax treatment that 529s enjoy now made permanent, these puppies remain the best way for serious savers to grow a dedicated college-costs nest egg. Contribution limits are high, and although you should give your own state’s plan careful consideration, particularly if it offers a tax break, you’re free to shop around.

Another smart choice: Coverdell Education Savings Accounts

What: A tax-favored investment account designed to help cover any qualified educational expense, including, for example, the cost of a private secondary school.

Eligibility: Provided you don’t exceed the income limits, you can kick in up to $2,000 per year. And if you do exceed the limits, you can gift the money to your beneficiary, who can then fund the account on his or her own.

Benefits: As with 529s, your investment will grow tax-deferred, and qualified withdrawals can escape the tax collector’s bite, too. Unlike a 529, the qualified withdrawals aren’t limited just to college costs, either. If you want to buy a computer for your high school sophomore, you can tap the account for that. And with a Coverdell, the market is your oyster: You’ll call the investment shots.

Our advice: The broader swath of educational expenses a Coverdell can cover is a fine feature, but the low contribution limit of $2,000 per year makes these accounts less appealing than 529s. And unless Congress acts, Coverdells will lose some luster come 2011, with pre-college costs, for example, being expelled from the qualified-expenses list. For now, though, consider contributing to both a Coverdell and a 529, particularly if you’re looking for a tax-smart way to pay for high school costs. But remember: You’re in the investment driver’s seat with a Coverdell, so keep your eyes on the prize. Ratcheting down risk as the need to tap the account approaches should be part of your game plan.

Don’t even think about it

529 plans and Coverdells aren’t your only options when it comes to prepping for college costs — they’re just the smartest ones. Not-so-smart moves include:

PTapping your IRA.

P You’re always free to withdraw your Roth IRA contributions without tax or penalty, and the IRS will even wave the 10% early-withdrawal fine on earnings (Roth) or contributions and/or earnings (traditional) if you use the money for qualified expenses. Still, you’ll have to pay taxes on any distribution from a traditional IRA and on earnings distributed from a Roth. For someone in the 28% bracket, that latter figure could be as high as $280 per $1,000 of earnings withdrawn — money that can stay in the account with a 529 or Coverdell. What’s more, if the distribution exceeds your qualified education expenses, you’ll cough up even more cash. Our advice: Just don’t do it.

Prepaid tuition plans.

These are 529s of a different color entirely. At first glance, they look appealing — who wouldn’t want to pay today’s tuition rates for a tab that will presumably be far pricier down the road? Alas, the fine print is worth reading. Although the private school-affiliated Independent 529 plan crosses state lines, prepaid plans generally guarantee only in-state rates: If your child is admitted to Harvard, a prepaid plan will probably pay out only the average cost of a state school. And if he or she opts not to go to college at all, don’t expect to receive much more than the contributions you kicked in.

We prefer 529 investment plans, whose value is tied only to the performance of the plans’ portfolios.