The Brainiest Way to Save for College

Good question. While parents have more choices than ever when it comes to saving for college, figuring out the best way to do it can be awfully confusing. The good news is that thanks to some generous new tax changes, there's no reason for you or your son to ever pay taxes on this college fund. But whose name you set up the account in could still have a significant impact further down the line. So here's what you need to think about.

First, let's talk about what type of account makes the most sense. As far as we're concerned, it's pretty easy: These days, 529 plans are the best deal around for most parents. Why? Because the account can grow tax free, you can contribute up to $250,000 and anyone can contribute — regardless of income. Withdrawals to cover college expenses are never federally taxed — and in many cases you can receive a state-tax deduction on your contributions and won't have to pay state taxes on the withdrawals. These accounts come in two basic flavors: college savings plans and prepaid tuition plans. Unless you're absolutely certain your son is going to an in-state school, we strongly suggest you go with the college-savings option. Click here for more details on both types of plans.

What's the catch? Well, if you want control over how the account is invested, you might find these plans too limited. Most college savings plans give you only a handful of mutual funds to choose from, and prepaid tuition plans don't give you any choice at all. If investing control is a priority for you, you could contribute up to $3,000 annually to a Coverdell Education Savings Account (ESA) (though keep in mind there are income restrictions) which also provides tax-free withdrawals for college expenses — and allows you to invest the account however you see fit. The remaining funds could then be placed in a taxable investment account with a brokerage house or fund family. For investment suggestions, take a look at our SmartMoney college portfolios. For a comprehensive comparison of the different types of college-savings plans and education-related tax breaks, check out our College Savings Superpage.

Now, choosing whether to save in your child's name or in your own is also a major decision. For starters, if you do decide to invest in a taxable account, the choice has significant tax implications. If it's held in your own name, any earnings will be subject to the regular tax rules — meaning long-term capital gains will be taxed no higher than 20%, while short-term gains (those held less than one year) and dividends will be taxed as ordinary income, which can run as high as 38.6% in 2002. If, on the other hand, you set up an account in your son's name, then he'll be subject to the kiddie tax. This means that during each tax year, the first $750 earned will be tax free and the second $750 will be taxed at the child's rate of 15%. Anything over that first $1,500 will be taxed at the parent's rate. After the age of 14, gains are taxed as an adult's. So from a pure tax perspective, less will go to taxes if you save in your son's name. (Of course, you can avoid all taxes if you follow our suggestion of investing in a 529 or Coverdell ESA.)

But here comes the curveball. Any type of account you set up — taxable, a 529 plan or a Coverdell ESA — could affect your son's eligibility for financial aid. Just how much depends, in part, on the type of account and whether it's held in his name, yours or someone else's. We'll give you the details below, but before you get too alarmed, keep in mind you should never let the fear of hurting your child's financial-aid eligibility prevent you from starting a college-savings strategy now. "You're better off saving than not saving," says certified public accountant Joe Hurley, who runs the very handy Web site Saving for College. After all, there are certainly no guarantees when it comes to financial aid. (See our financial aid calculator for an estimate of how much aid your son may qualify for.)

Even so, before you begin any investment strategy, you should understand the potential financial implications as best you can. And as confusing as this all is, you should keep in mind that schools are constantly changing how they assess financial aid, so what's true today may not be true by the time your son trundles off to school.

Generally speaking, when it comes to financial aid, you're better off not holding assets in the child's name. That's because under the federal methodology (the criteria used by most public institutions like state universities), you're expected to contribute a maximum of 5.6% of parental assets toward a child's tuition every year. But a student is expected to kick in 35% of his own assets. What's worse, any income is assessed at 50% for students, 47% for parents. Private institutions have their own methodology for awarding financial aid. In fact, some elite private schools have begun combining parent and student assets and assessing them at the lower parental rate rather than separating them, says Hurley.

Now, when it comes to the tax-free plans, like the 529 plans, no one is really sure how schools will assess the income they produce. That's because financial-aid offices often use the previous year's tax return to assess a student's financial-aid eligibility. But now that 529 earnings are no longer considered taxable income, that information may no longer be included on a tax return for review, explains Hurley. Nevertheless, for a review of how 529 plans are currently assessed, click here.

If this is a serious concern for you, here's an idea. A little-known fact is that currently most financial-aid formulas don't ask for grandparents' assets, says Kalman Chaney, author of "Paying for College Without Going Broke." So you could consider handing that check back to granny and having her set up an account herself. Just keep in mind, should your son fall out of her good graces, she could change the beneficiary. So make sure he sends her a nice thank-you note for such a generous gift.

For more on saving for college, visit our college planning section