The sooner you start saving for college, the better.
But plan ahead before you start. How you save is almost as important as what you save.
Here's a rundown on some of the important options:
Custodial accounts. The first decision you have to make is whether to save the money in your name or your child's. Accountants often recommend setting up accounts for children because the earnings are taxed at your child's rate, instead of your higher rate.
The unintended consequences of this strategy include a possible loss of financial aid eligibility (since student assets count more than parents' assets in financial-aid formulas), and a loss of parental control of the money when your child reaches 21, or 18 in some states.
If you don't think your child will be eligible for financial aid, getting the tax break might be worth having the money in your child's name. But be careful: Financial-aid rules will likely change, possibly this year.
Individual retirement accounts. Money grows tax-free in the new Education IRAs and Roth IRAs, just as it does in conventional IRAs. But Congress added a bonus: Withdrawals from these accounts to pay for education costs are also tax-free, after five years, whereas withdrawals from conventional IRAs are subject to income taxes.
The maximum annual contribution is $500 for the Education IRA and $2,000 for the Roth. Unlike conventional IRAs, contributions are not tax-deductible. Congress may boost the Education IRA limit to $2,000. (Editor's note: Stay tuned for more on the Roth IRA next week.)
Prepaid tuition plans. These are described in the nearby story. With all the strings attached to these state programs, experts say parents should think twice before signing up.
Tuition discounts. To compete with state prepayment programs, Federated Investors, a large mutual-fund company, has teamed up with 90 private schools to offer this program. Participating colleges (sponsors hope to sign up 500 colleges) agree to offer families a discount of 5 percent of the money contributed to the program. Current tuition rates are not locked in, and the maximum discount is the lesser of $13,800 or one year's tuition. There are no penalties if your child decides not to attend one of the participating colleges. You just give up the discount. The money can be invested in any of Federated's mutual funds, with a minimum initial investment of $2,500.
Savings bonds. If you are 24 years or older, you can buy savings bonds in your name and redeem them for college expenses for your children, without paying taxes on the interest earned by the bonds. But with the bonds presently yielding about 5 percent, your money won't grow fast enough meet college costs. In addition, the tax benefit is phased out for families at higher income levels.