College plans for the rich, poor and in-between

Finding the right investment vehicle for your college savings isn't easy. For every article touting a method for protecting and growing your fund, you'll find another warning of its drawbacks.

Depending on what you read, state-run Section 529 college savings plans are either the best thing since sliced bread or a trap for the unwary. Coverdells (formerly Education IRAs) are either better than ever or not ready for prime time. UTMAs (Uniform Transfers to Minors Act), UGMAs (Uniform Gifts to Minors Act) and other custodial accounts are hopelessly outdated or hopelessly underutilized.

The reality is that no one college savings method works well for every family. The right way for you, personally, to save for college depends on several factors, including:

• Your tax bracket

• Your child's age

• How much control you want over your investments

• How much financial aid you expect to get

Many people don't realize that financial aid is based largely on income -- primarily that of the parent, but also that of the student. (Assets matter, too: The typical college will want the student to spend 35% of his savings on college costs, while the parent is expected to pony up 5.6% of certain assets each year.)

Keep your expectations real

Caveat No. 1: The following breakdowns assume that your child is relatively young. If you've got five years or fewer until your first tuition bill comes due, you may want to skip the tax-deferred options, said Kathy Kristof, author of "Taming the Tuition Tiger: Getting the Money to Graduate."

That's because you really don't have enough time to earn much in the way of investment returns, so tax breaks on earnings are of little benefit. Saving in taxable accounts will give you more freedom, since you won't have to deal with the restrictions that come with tax-deferred accounts.

Caveat No. 2: Loans, not grants or scholarships, make up about 60% of financial aid packages. So even if your savings do reduce your ability to get financial aid for your child later, don't sweat it overly: You're simply sparing him or her future debt.

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Caveat No. 3: These strategies assume the tax laws will remain pretty much the same until your kids are grown. That's a pretty big if. Should Congress make major changes, you'll need to revisit your strategies.

The lowest brackets

• $29,700 for single filers

• $39,800 for heads of household

• $59,400 for married filing jointly

If you're in the lowest brackets, you don't benefit all that much from tax-deferred accounts because you don't pay that much income tax to start with. You also probably won't be able to save the huge amounts that might make tax deferral a better deal.

But you do have the best shot at getting significant financial aid. So your guiding principal should be to save in ways that don't mess with your child's ability to earn scholarships and grants later. Here are some dos and don'ts for your tax bracket:

Keep your savings in your own name. Parental assets count less heavily in financial aid calculations. Today's lower tax rates on capital gains and dividends means you could pay as little as 5.6% on your savings. Plus, you have the flexibility to use the money any way you want.

Consider beefing up your home equity or retirement savings. Most colleges don't count these assets at all. If your child makes it into an elite private school that does, you'll still be expected to spend only a small portion of these savings on his education.

Think twice about Coverdells or 529 plans. These plans allow you to set aside money that can grow tax-deferred and that's entirely tax free if used for qualified education expenses. You can contribute only $2,000 a year to a Coverdell, while 529 plans typically have much higher limits (a total of more than $200,000 in many states). The tax benefits make them a pretty great deal for higher-income parents, but they have some potential drawbacks:

• You can't claim the valuable Hope or Lifetime credit for school expenses you pay with Coverdell or 529 plan funds. (These credits aren't available to singles and heads of household with AGIs over $52,000 or marrieds with AGIs over $104,000.)

• If you don't end up spending the money on qualified college expenses, you'll face taxes and penalties. Coverdells (formerly known as Education IRAs) must be spent by the time the beneficiary reaches age 30, or the tax consequences kick in. There's more flexibility in state-run 529 plans, where funds can be shifted to another child's account or even used by the account owner for qualified education expenses. Still, if you don't use the money for school or need to withdraw it for other expenses, you'll face income taxes and 10% federal penalties.

The good news is that Coverdells and 529s don't hurt your ability to get financial aid as much as was once feared, said 529 guru Joseph Hurley, a CPA who runs the Savingforcollege.com Web site. The money typically is treated as the parents' asset, and distributions aren't counted as either the student's or the parent's income as long as the cash is used for qualified education expenses.

Don't invest in custodials. Custodial accounts include UTMAs (Uniform Transfers to Minors Act) or UGMAs (Uniform Gifts to Minors Act). Colleges consider these accounts to be the students' assets, which will count heavily against them when financial aid packages are calculated.

What if you already started saving in custodials? All is not lost. If you spend down your custodial account money before your child is a junior in high school, the money won't count against her. (Custodial account money can be spent on anything that benefits your child, from camp to a computer to a car; just don't use it on stuff you're required as a parent to supply anyway, like food, clothes or shelter.)

Only spend down the account, though, if you would have incurred these expenses anyway and can put an amount equal to what you've spent into savings in your own name. As Kristof notes, you don't want to throw away $1 in savings just because you might lose 35 cents in future financial aid.

Massed in the middle

• $71,950 for single filers

• $102,800 for heads of household

• $119,950 for marrieds filing jointly

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