College savings plans that will make the grade

With the cost of higher education continually rising, it's more important than ever to get an early start saving for a child or loved one's college education. For parents or grandparents considering the possibilities, Section 529 state-sponsored college savings plans may be the way to go.

The ABCs

College savings plans allow you to invest significant sums of money that can grow tax-free. You can set up an account for anyone: Your child, grandchild, niece, nephew or even yourself. These accounts grow larger than an identical taxable account where earnings are taxed every year.

When the money withdrawn is used to pay for qualified education expenses, including tuition, fees, certain room and board expenses, supplies and equipment, it's free from federal income tax. Many states also extend favorable tax deductions and tax-free withdrawals to state residents. Check with your tax advisor to see if this is an option.

Contributions to college savings plans are usually invested in one or more predetermined structured portfolios. Typically, plans include age-based or years-to-enrollment portfolios that become more conservative as the child nears college enrollment. Early on, the portfolio will usually hold more stocks; as college approaches, the portfolio will automatically include more fixed-income investments in order to help reduce the risk of stock market volatility on money needed in the near future. Other options include static portfolios that do not alter their investment allocations over time; as well as individual fund portfolios that allow for a greater degree of customization. The performance of the portfolios depends on market conditions and there is no guarantee that there will be enough money in the account to cover all education expenses.

Do the Math

To fully understand the benefits of 529 plans, it's a good idea to compare how they stack up against more traditional plans. If you've started to explore education-funding possibilities, you have probably found that most traditional savings plans come with limitations. For example, with an Education Savings Account (formerly an Education IRA) you can only save $2,000 a year, not much given that tuition, room and board can sometimes cost tens of thousands of dollars for a four-year education.

While these accounts do provide tax-free distributions, parents with relatively high incomes may not be allowed to contribute.

Custodial accounts present other dilemmas. The child owns the assets since the account is in his or her name, but the latest changes in the taxation of unearned income by minors has been extended all the way through age 18, and up to age 24 for college students. That means you can only hope that your college-bound teen decides to use the money for college, but no matter how the money is spent, much of the investment income will be taxed to you at your highest marginal tax bracket.

U.S. Savings Bonds are also a popular savings vehicle. However, these bonds carry modest interest rates.

Do Your Homework

There are a couple of things you'll want to consider when evaluating 529 plans.

First, find out about your state's college savings plan. Keep in mind that where you live may or may not be the best place to invest. Most states allow accounts to be opened by non-residents. If your state has a college savings plan, you should weigh any local tax benefits against the benefits and conditions of plans offered by other states. Also, if you are already saving within a custodial account, an ESA, or with U.S. Savings Bonds, you may want to explore the tax-free transfer of these savings to a college savings plan.

Finally, keep in mind that if the funds aren't used for educational purposes, you'll face a 10 percent penalty tax on earnings upon withdrawal. Still, many families find the benefits of the plans greatly outweigh any potential disadvantages. Last year alone American families invested around $5.5 billion.

Spell out Your Goals to a Financial Advisor

Your Financial Advisor can provide more information, as well as help determine which plan may be best for you based on you unique situation. Whatever path you take, remember, these plans offer a great way to prepare for your child or loved one's college education.

For more information, e-mail william.a.creekbaum@smithbarney.com or call 689-8700.

Smith Barney does not provide tax and/or legal advice. Please consult your tax and/or legal advisors for such advice.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.