Preparing for the tuition test

Education IRA Anyone (parents, grandparents, etc.) can set aside $500 per year per child in an education IRA account. The account can be a savings account or make investments.

If the child uses the money for an eligible higher-education institution, such as a university or a vocational school, before age 30, the earnings are tax free. And if the child decides against college, you can transfer the money to a sibling.

A child can have multiple education IRAs, but total, annual deposits cannot exceed $500 per year.

Prepaid tuition plans Many states, such as Maryland, Colorado, Ohio, and Massachusetts, let you lock in today's tuition cost at a public college or university by paying now. By the time your child arrives, the tuition is paid.

Different states have different rules, but generally, if your child decides to attend a different college, you get your money back plus a preset return.

If your child skips college, you can get your money back, minus a penalty. You cannot set up an education IRA the same year you pay into a prepaid tuition plan.

Mutual funds, stocks, bonds Over the long run, the stock market has historically outperformed other investments, but it has risks. Mutual funds lessen the risk while keeping the returns.

Savings bonds Federally-backed savings bonds are a low-risk, low-yield investment, but their return is better than a bank savings account's.

The current rate for new series EE savings bonds is 4.6 percent. Series EE savings bonds are purchased for 50 percent of face value.

New Series I bonds sell at face value, and accrue interest based on a fixed rate of return and a semiannual inflation rate.

Both types avoid state and local income taxes on the yield, and they are free of federal taxes if used for qualified education expenses.

Zero-coupon bonds Basically, you buy a piece of a Treasury bill (Treasury STRIPS) or municipal bond (Stripped Muni) at a deep discount to face value.

A $1,000 Treasury STRIP due in 18 years would cost about $375 and pay its face value at maturity. The advantage: The interest rate is fixed, and the investment is safe. Buy these through a broker.

Savings accounts Most savings institutions will waive minimum-balance requirements and services charges for savings-account customers younger than 19. These accounts are safe, but interest rates are low - less than 2 percent. Credit unions usually pay a bit more than banks.

Tax credits Two new tax credits became available last year. The Hope Credit is $1,500 a year maximum for a student's first and second years of a qualified higher-education institution. The Lifetime Learning Credit maximum is $1,000 per year per student. You cannot claim both credits in the same year. And income limitations apply.

For specific tax information contact your tax adviser or visit the IRS Web site at www.irs.ustreas.gov

Traditional IRAs You can tap the money in your regular IRA to help fund college tuition. Normally, a nonretirement withdrawal carries a penalty, but not if the money goes to pay college tuition.

But you do have to pay taxes on whatever profits have accumulated in the IRA. Just tell whatever company holds the IRA that you're withdrawing the money to pay for college tuition.