My husband and I are expecting our first child in December, so we're thinking about how to save for college. Tuition at public colleges is up 5.6 percent a year above inflation for the last decade, according to the College Board; if that trend continues, sending our bundle of joy to out-of-state U is going to cost upwards of $157,000, plus room and board, starting in 2018.

The good news is that parents and grandparents have a lot of options to save for college. The three most important concerns for most families are picking a safe investment vehicle with decent returns, finding the best tax advantages, and avoiding being penalized for saving when it comes time to apply for financial aid at the college of your choice.

Here's a rundown of the options as I see them, from best to worst. Remember: Don't put away money for the kids' college without first paying down debt and saving for your own retirement.

529 College Savings Plans

Under Internal Revenue Code section 529, all 50 states and the District of Columbia sponsor tax-advantaged investment accounts for education expenses. Much like a Roth IRA, your contributions to a 529 are subject to federal tax, but the earnings in the account are not; nor can you be taxed on the money when you take it out, as long as you spend it on qualified education expenses such as tuition at an accredited university. If you live in one of the 34 states (or D.C.) that offer state tax advantages for 529s, choose your own state's plan; if not, or if you live in Arizona, Kansas, Maine, Missouri or Pennsylvania, which offer state tax advantages for all 529 plans whether in-state or out-of-state, choose whichever state's plan you like the most. All 529 plan details are listed on the College Savings website: http://www.collegesavings.org/index.aspx.

To limit fees and commissions, you want a direct-sold 529, rather than one sold through a broker. As always, you should also choose the lowest-cost investment options; two to look for are Vanguard index funds or the Fidelity Spartan 500 index funds.

Coverdell Education Savings Accounts

A Coverdell ESA has the same federal tax benefits as a 529, but it has an annual contribution limit of $2,000 and a household income limit of $190,000, and there are no state tax benefits. Some families may appreciate that Coverdell contributions can be used for elementary, middle and high school tuition, as well as for college or grad school.

Prepaid tuition plans

Another kind of 529 plan is a prepaid tuition plan. In 17 states, you can invest an amount equivalent to one semester of tuition in your state university system today, and the state guarantees that your investment will be worth one semester's tuition 18 years from now. It's a simple investment that provides peace of mind and a decent rate of return, as public university tuition has been rising about 6 percent a year. Prepaid tuition is also a hedge of sorts against economic downturns: Tuition tends to rise even more in years when the market is sinking. The obvious disadvantage to a prepaid tuition plan is that it locks your child into attending her state university. Some states honor other states' prepaid tuition plans, but you may have to pay the difference between an in-state and out-of-state student. There's also a risk that plan costs will rise, or that the state will not be able to honor its obligations.

UGMA and UTMA accounts

The Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) offer an easy way to purchase stocks or bonds in a child's name. Funds from these accounts don't have to be used for education expenses. Investment income in these accounts above a certain threshold may be taxable. Contributions are irrevocable, and can't be easily transferred to another child in the family. But the major drawback, from the point of view of saving for college, is that UGMA and UTMA assets hurt a student's eligibility for federal financial aid more than assets in a 529 or Coverdell plan.

Twitter: @ihavenet

 

 

Recent Personal Finance Articles

 

Personal Finance - What's the Best Way to Save for College?

(c) 2011 U.S. News & World Report