Investment Basics: Starting a college fund

"If you don't save enough, the college money might have to come from current cash flow," warns Mary Malgoire, a financial planner with The Family Firm in Bethesda, MD. "That means you'll need to keep working longer. Meanwhile, you may be forced to cut back on funding your retirement plan or putting enough aside for other needs."

Even though these huge bills are coming due in the next 10 or 15 years-or sooner, and for more than one child-paying for your kids' education doesn't have to loom as an enormous threat to your financial well-being. College savings plans are being improved, and tax laws make investing and saving for higher education much easier.

Take a new look at 529 savings plans. If you have young children and a long investment horizon, your best bet may be a Section 529 plan, (This financial term and others-they're italicized- are defined in the glossary at the end of this article) named for the part of the IRS code that regulates it. Already a popular choice, 529 college savings plans became even more attractive in August, when President Bush permanently extended their federal tax benefits. You'll continue to pay no federal tax on the earnings in these accounts, as long as they're used to pay for higher education, and the monies will count against you or your child at no more than 5.6 percent of their value when applying for financial aid. Many states also offer residents a tax deduction on 529 plan contributions to their in-state plans, and most exempt the plans' earnings from state income tax. (A few states even extend tax deductions to residents who invest in other states' plans.) The funds can be used for tuition, room and board, and other expenses at just about any college or university in the country. The few exceptions are those schools that don't participate in federal financial aid programs; if you're unsure, check with your state's 529 plan.

All states except Wyoming have 529 plans, and many of them welcome investors who aren't residents. Each plan offers different mutual fund options, many of which are managed by big investment houses like Fidelity and Vanguard. For example, at TIAA-CREF, which handles 11 state-sponsored plans, parents typically have a choice of options that include an all-equity fund, a conservative fixed-income fund, or an asset allocation fund that shifts to a less aggressive portfolio as the child ages.

The 529 plans have several more advantages, too. Unlike Coverdell Education Savings Accounts (formerly called Education IRAs), which have a $2,000 annual limit, 529s let you invest large sums-up to a total of $300,000 in some programs. In addition, these plans offer grandparents a way to move assets out of their estate tax-free. Donors can combine five years of tax-free gifts, which means a married couple can give $120,000 to each grandchild at one time.