Editor's Note: Read Part I here.

Choosing the Right Account

The college savings landscape is dramatically different today than a decade ago. Back then, the most popular vehicles were EE savings bonds, UGMA custodial accounts, and state-sponsored prepaid tuition plans. The savings bonds offered tax advantages but were an inferior investment product. The UGMA accounts offered the opposite—better investing options but potential tax drawbacks. Changes to the tax laws in 1997 and 2001 have eliminated those tradeoffs for most college savers, allowing them to now invest on a tax-free basis without having to settle for either inferior investment products or giving up control of the money invested. As a result, EE bonds and UGMA accounts have fallen dramatically out of favor, and it's the rare family that should even consider using them at this point.

State-sponsored prepaid tuition plans promise that your investment in the plan today will cover tuition at any school in the state no matter what the cost at the time your child enrolls. Consider this recent example from Florida's College Prepaid Program: For the enrollment period that just ended, a lump sum payment of $16,808 for a child in the third grade would cover all of the child's future tuition and fees for four years at a state university—guaranteed. The price is locked in regardless of future increases in state tuition.

Due to the rapid rise of college costs in recent years, some states have either stopped accepting new participants in their prepaid tuition plans, or have made the pricing options less attractive. As a result, fewer parents have access to a compelling prepaid tuition plan. Still, they offer a no-risk alternative to paying for a college education. However, as with most no-risk investments, the internal rate of return typically isn't that great. In addition, there are some limits on how flexible these plans are, so be sure to find out ahead of time what the implications are if Junior decides to break a five generation tradition and forsake Home State U. (gasp!) in favor of its arch rival in the next state.

Unless the guarantee aspect of the prepaid plans is very important to you, we suggest that you instead look to the newer college planning options—Coverdell Education Savings Accounts, Roth IRAs (surprise!) and Section 529 plans. They provide superior tax advantages and planning flexibility. Let's take a quick look at the pros and cons of each of these kinds of accounts.

Coverdell Education Savings Account (ESA). Created in 1997 as Education IRAs, and improved dramatically in 2001, Coverdell ESAs are a compelling savings vehicle for parents who meet the contribution limits. Parents filing jointly with adjusted gross income below $220,000 may contribute up to $2,000 per child, per year, to a Coverdell ESA. The contribution is not deductible, but all earnings grow tax-deferred, to be distributed tax-free if used to pay the beneficiary's college expenses. $2,000 per year may not seem like much, but it adds up if you start early. Contributing $2,000 per year for 18 years with an earnings rate of 10% would accumulate to just over $100,000.

While Coverdell ESAs and Section 529 plans both offer the prospect of potentially tax-free earnings, only Coverdell's and Roth IRAs offer the flexibility to choose the specific investments you desire. Section 529 plans don't, as we'll see shortly. This is a big advantage to using a Coverdell or Roth IRA for those who want to direct their own investment program, as many Sound Mind Investment readers like to do. (Most fund companies or brokerages can set up a Coverdell ESA and/or a Roth IRA for you, allowing you access to their full range of investment products.) In addition, the favored tax treatment of Coverdell earnings extends, for now, to cover elementary and secondary school expenses. The list of qualified expenses is lengthy, and includes both obvious items like tuition and books, as well as non-obvious items like uniforms, transportation, even computers and Internet access for the family during the years the beneficiary is in school.