How to Pass the Tuition Test

Wha

t's the best way to save for college? This isn't a multiple-choice question." So says a new ad from Fidelity soliciting contributions to its Section 529 State Sponsored College Savings Plans. But the ad is wrong. You do have a number of choices. Though changes in U.S. tax laws that take effect this year make saving for education more attractive, they also make it more complicated. Choose from among these answers:

A. 529 SAVINGS PLAN. This plan allows you to put away as much as $268,000 per child, gradually or in a lump. The money grows tax deferred, and withdrawals are tax free starting this year through at least 2010, the year the Bush tax law expires. You may also get a state tax deduction if you contribute to your state's plan.

B. A COVERDELL EDUCATION SAVINGS ACCOUNT. Formerly known as an Education ira, it allows annual contributions of $2,000. The money goes in after you've paid income tax on it, but withdrawals are tax free. And you can use the proceeds for grade-school expenses in addition to college costs.

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C. A UNIFORM GIFT TO MINORS ACCOUNT. For this, you invest money in your child's name. The first $750 in annual earnings is tax free.

D. NONE OF THE ABOVE. The correct answer: D. "Paying for college is a retirement problem as much as it is a funding problem: How do you pay for school and still have enough left over to retire?" says Kalman Chany, author of Paying for College Without Going Broke. That's why your first dollars need to go into your 401(k), where the money goes in free of income tax and grows tax deferred. Nine times out of 10, you will get matching dollars from your employer. And 401(k) savings are not counted when colleges determine whether your child is eligible for financial aid.

If after funding your retirement, you still have money left to save for college, you should look for a tax-advantaged home for your money, which means choosing A, B or C. Which one (or ones) depends on your income, your kids' ages and whether you anticipate qualifying for financial aid. Here's a pecking order:

First, put a few thousand dollars into an UGMA account, particularly if you're not likely to qualify for financial aid. The downside is that once your children hit 18, the money can be used at their discretion. But even if they are not college-bound, you're not liable for withdrawal or tax penalties.

Next, if you have kids under age 8, fund a Coverdell ESA. Why? There's a chance that withdrawals from a 529 may be taxed again beginning in 2011. Not so with Coverdell withdrawals. And you control how the money is invested, which is not the case with a 529. Even if you earn too much to contribute to a Coverdell for your kids--more than $190,000 for singles or $220,000 for couples--perhaps a grandparent or other relative doesn't. Financial planner Judy Miller, of College Solutions in Alameda, Calif., suggests giving the money to the child and letting him or her make the contribution independently. Using a Coverdell for expenses during middle and high school also makes sense. "If you know you're going to buy your kid a computer in high school," Miller says, "you can put the money in the Coverdell and buy it on a tax-free basis."

Last on the list comes the 529. But that doesn't make it least. After you max out your 401(k) and contribute to an UGMA and a Coverdell, 529s make sense because they allow you to put away so much money so quickly. They're treated as assets of the owner of the plan rather than the child, which is a plus where financial aid is concerned. And even if tax-free withdrawals are revoked, having the assets taxed at the child's rate isn't all that bad. "Most students are in a low tax bracket anyway," notes Joseph Hurley of Savingforcollege.com.

Jean Chatzky can be reached at moneytalk@moneymail.com