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Crunching Numbers On College Savings

It was time to hit the books -- or, in this case, the Internet.

President Bush's tax reforms caused my husband and me to second-guess the account we'd chosen for our son's college savings. Two years ago, I'd spent many exhausting hours online researching our options before deciding on Roth IRAs.

See a chart of Web sites that offer details about saving for college

But since I needed to be sure that our first choice was still the best, I logged on with a measure of dread and began the painful process all over again.

Here's what I found:

Step One: Price Check

Aside from a two-year-old galloping across the room with scissors in hand, there are few things more hair-raising than the six-digit sum staring back from a tuition-cost calculator.

While dozens of Web sites offer calculators that estimate financial need, the best I found was Microsoft's MoneyCentral college-savings calculator because it let me customize my expectations on what costs will be and took into account that I already have savings set aside.

After punching in where we live, an estimate of our annual income, the balance of our current savings accounts and number of years until our son begins college, I was asked to estimate our rate of return (after being badly burned in the recent tech meltdown, I chose a more conservative 7%).

The calculator then grilled me on whether earnings on our accounts were tax-deferred (yes) and whether we'll have to pay capital-gains taxes when we cash in the investment (no). It then factored in the average rate of tuition-cost increases and the length of time my son will be in college.

Turns out my scaled-back assumptions on what our savings might earn over time boosted the amount of money we'll need to set aside each year by almost $1,500, in order to afford a four-year public college education at $163,843.

(Note to self: Cancel subscription to Early Retirement magazine.)

Step Two: Narrow the Field

With so many institutions getting into the business of college planning, it's tough to know whether your money is being invested in a product that fits your financial goals.

Add in the uncertainty whether the tax advantages you'd enjoy will be there tomorrow. Many provisions of the recently passed Tax Relief Act won't be fully phased in for years, and all are set to expire by 2010 unless Congress extends them.

As young parents of a toddler, in a household of somewhat limited means, we were looking for an account that would allow us to invest about $4,000 a year and a give us maximum earnings and control.

Luckily, Fidelity Investments' Web site features a helpful chart that let me quickly compare each plan. I easily eliminated a number of options as unsuitable for us:

Prepaid-tuition plans: Earnings in these accounts grow tax-free until the money is withdrawn by the child, when it is taxed at a lower rate. Prepaid-tuition plans also let you lock in tomorrow's tuition rate today, and best of all grandparents, friends and others can contribute to the account. Sounds great. But every dollar earned in the account reduces the amount of money our son can obtain through financial aid; we'd have no control over how the money's invested; and, depending on the plan, if our son opts against college or goes to college out of state, we may get our capital back but forfeit all earnings.

Education IRAs: The Bush tax plan raised the annual limit on education IRA contributions to $2,000 from $500, and tax-free withdrawals also may be used for primary and secondary-school tuition.

But you aren't allowed to take a Hope or Lifetime Learning tax credit in the same year you withdraw funds from your education IRA, a benefit you can keep with other accounts. Hope allows a $1,500 credit for tuition and fees for students in their first or second year of college, for as many of your children who qualify. The Lifetime Learning credit, worth up to $1,000, is good for one child only but it's available to a student in any year. You can't use both the Hope and the Lifetime credit for a single student, but you can split the credits if you have two children at school at the same time.

So the education IRA was not the right fit for us because of our need to maximize tax savings over time.

College CDs: I logged on to the Web site of the College Savings Bank of Princeton, N.J., which introduced the College CD. These certificates of deposit are indexed to college costs and guarantee that you'll earn a percentage rate at least equal to the average increase of the cost of attending college. There's no ceiling for savings here: As with regular CDs, the money is federally insured for up to $100,000. And if my son ditches college or, better yet, gets a full scholarship, we'll get all of our principal and interest back when the CD matures and can use the money as we wish.

Not bad, but even though my bull-market fever has faded I still think it's possible for our savings to do better than the average 5.36% over a 10-year period that college costs have increased, according to College Bank's Web site. Since we won't need to tap the money for more than 15 years, I'd rather take my chances in the stock market, where gains have been higher.

After visiting only two Web sites, I had swiftly trimmed a long list of potential college-savings vehicles to two: 529 plans and our initial choice, Roth IRAs.

Step Three: The Final Cut

The Bush tax reforms substantially boosted the benefits of 529 plans for college savings.

These state-run, college-savings plans (which fall under Internal Revenue Code Section 529) have all the benefits of prepaid-tuition plans but few of the drawbacks. Anyone can open an account and invest more than $150,000 in some states, regardless of your level of income. Earnings grow tax-deferred and in a number of plans you can use the money at any school in the nation.

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