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With student loan debt gradually becoming what some believe will be the next major financial crisis, saving for college has never been more important. Yet, as if figuring out the best investments for a regular portfolio weren't hard enough, parents saving for college have to navigate an even more complex array of different accounts, each of which has pros and cons. Added to the difficulties involved in finding extra cash to set aside in the first place, it's no wonder that so many parents simply punt and hope their child gets a dream scholarship.
But the right solution for college savings doesn't involve finding one perfect solution. Instead, by cobbling together an overall strategy using all the tools at your disposal, you'll likely end up in far better shape than you would if you simply chose a single option and hoped for the best.
I don't think there's a Hallmark card for this one
Yesterday was officially "529 Day," a celebration that various college-savings advocacy groups latched onto on May 29 to raise awareness of one of the more popular methods for saving for college: the 529 plan. Named after the section of the Internal Revenue Code that authorizes them, 529 plans promised to do for college saving what 401(k) plans did for retirement saving: provide a simple way to set aside money for college using a variety of easy-to-understand investment options. A dozen and a half 529 plans offered special incentives, including small scholarships and account application fee waivers.
529 plans give savers a lot of perks. Tax-deferred growth that becomes tax-free when money is used for college expenses can be worth a lot when investments are actually going up in value. But too many account holders have seen their savings go more or less nowhere over the past several years as the market meltdown took away much of their hard-earned savings, leaving them to claw back to break-even over the past three years. That's one reason why Fifth Third Bank (Nasdaq: FITB ) , Zions Bancorp (Nasdaq: ZION ) , and other banking peers have started offering insured CDs and savings accounts within 529 plans.
Even in good markets, 529 plans aren't perfect. Some plans have fairly expensive investment options, as money managers AllianceBernstein (NYSE: AB ) , Franklin Resources (NYSE: BEN ) , and Hartford Financial (NYSE: HIG ) include actively managed options that charge much more than index-fund choices that other plans offer. Sometimes, those active funds earn enough extra yield to pay for their higher fees, but often, they fall short.
Why you need a broader mix
The better approach to college savings combines several different tools at your disposal. If 529 plans are the collegiate equivalent of 401(k) plans for retirement, Coverdell Education Savings Accounts act more like Roth IRAs. Unlike 529 plans, Coverdell ESAs let you invest in just about anything you want. But with annual contribution limits of just $2,000 -- and the potential for those limits to drop to just $500 in the future -- they won't get the job done by themselves.
Custodial accounts don't carry the obvious tax breaks that 529 plans and Coverdell ESAs offer. But assuming your child is in a lower tax bracket than you, you can effectively cut your tax bill by putting assets in your child's name and including their income on your child's return. The challenge with custodial accounts is that when your child reaches the age of majority in your state -- typically 18 -- you're required to turn over assets to the child. Many parents feel uncomfortable giving their children that amount of freedom.
Finally, simply keeping assets in a parent or grandparent's name retains maximum flexibility to invest and spend for expenses that might not otherwise qualify for favorable treatment in tax-favored college savings accounts. Even better, you typically won't have to include a grandparent's assets on financial aid forms, ensuring that savings doesn't penalize your child from aid packages.
Do the right thing
With all the different financial demands vying for your attention, saving for college is one that's easy to put on the back burner. But the sooner you start, the better the chances that you'll save enough over time to make a big difference in your child's life -- and help keep your child away from what could become crippling debt from student loans.
But once you've got your various accounts set up, the next step is figuring out exactly what to invest in. The Motley Fool's special report on long-term investing has some tips you can follow for any long-term goal, including retirement or college savings. You'll also find three time-tested stock names that could produce attractive returns over the long haul. I invite you to click here and start reading your free copy right now.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.