New Way to Save

By Daniel Kadlec

The best college-savings program you never heard about keeps getting better. As you think about year-end tax moves, consider dropping some cash into a state-sponsored plan where money for college grows tax-deferred and may garner a fat state income tax exemption as well. This plan is relatively new and often gets confused with more common prepaid-tuition plans, in which you pay today and attend later--removing worries about higher tuition in the future. Savings plans are vastly different and in most cases superior because they are more flexible.

Prepaid plans offer tax advantages, and some are portable, but many still apply only to public colleges within the taxpayer's state. What if Junior gets accepted to Harvard? You can get your contributions back. But some states refund only principal, beating you out of years' worth of investment gains. And state prepaid plans make it tougher to get student aid because the money is held in the student's name. With savings plans the money is in a parent's name, where it counts less heavily in student-aid formulas--and you can set aside as much as $100,000 for expenses at any U.S. college.

Both the prepaid and the college-savings plans vary from state to state. Check out the website collegesavings.org for details. It's a fast-moving area. In the next few months, eight states will join the 15 that already have state college-savings programs. Those are mostly in addition to the 19 that have prepaid-tuition plans. Only Massachusetts will probably offer both.

Most of the newer savings plans make contributions deductible against state taxes. New York, for example, launched its plan two months ago. It permits couples to set aside up to $10,000 a year per student and lets New York residents deduct the full amount from their income on their state return. Missouri will approve a tax-deductible savings plan in December. Minnesota is expected to adopt a plan in which the state matches 5% of your contributions. These college-savings plans are open to everyone, regardless of income--in contrast to the Roth IRA and other federal savings plans, in which eligibility begins to phase out for couples earning more than $100,000.

If your state doesn't offer a college-savings plan, you can still participate through an out-of-state plan. You won't get the state tax deduction, but you will get tax-deferred investment growth; and when the money is tapped, it will be taxed at the student's rate (usually 15%). Fidelity Investments (800-544-1722; www. state.nh.us), which runs the New Hampshire savings plan, and TIAA-CREF (877-697-2837; www.nysaves.org) which runs the New York plan, make it easy. If your state later offers a savings plan with a tax deduction, you can transfer your account penalty free.

Both plans invest mostly in stocks in the early years and slowly shift into bonds and money markets as your student nears college age. You get no say in this allocation. The impact of tax deferral is big. TIAA-CREF estimates that someone in the 28% tax bracket saving $5,000 a year and mimicking its investments in a taxable account could expect to accumulate $167,000 in 18 years. Deferring taxes and then paying them at 15% brings the total to $190,000. The state deduction, for those who qualify, pushes the nest egg to $202,000.

See time.com/personal for a complete list of state college-savings plans and phone numbers. E-mail Dan at [email protected]