Vehicles for college saving vary in the level of risk, tax benefits, and the amount that can be saved. They also come with limits on qualifying income. Be sure to thoroughly investigate your options.

529 College Savings Plan

A 529 savings plan allows you to save money tax-free—if it is used for qualified educational expenses. Annual investment limits are very generous, allowing for substantial college savings. Each state has different rules, fees, and limitations for these accounts. You are free to use any account from any state, though there may be benefits for state residents. These accounts are best held in a parent's name so they are counted at the parent's low assessment rate in financial aid calculations.

529 Prepaid Tuition Plan

A 529 prepaid tuition plan is a savings account that allows contributors to pre-pay tuition, locking in a total tuition cost that is lower than they would otherwise pay. Some states offer these plans for in-state public colleges. A private college plan is available for over 270 private colleges. Students and families should be confident the student will attend an in-state college or a private college covered by a tuition plan. Some plans, however, offer options to transfer the assets to other schools or beneficiaries if the student's plans change.

Coverdell Education Savings Account (ESA)

An ESA allows you to invest money for the benefit of a child until the child is 18. Earnings can be withdrawn tax-free when the student begins college, as long as withdrawals don't exceed qualified expenses. Although their annual investment limit is low compared to other college savings vehicles, ESAs make an excellent option when used in combination with other investments and if started early in the student's life.

Individual Retirement Account (IRA)

Traditional and Roth IRAs are savings accounts intended for retirement, but account owners are also allowed to use them for qualified college expenses without penalty. Many people choose a Roth IRA for college saving because of its flexible rules for withdrawing money before retirement age, and because the earnings are generally tax-free. This option is best for those who have sufficient sources of retirement income from other investments.

Savings Bonds

EE/E and Series I Savings Bonds are guaranteed by the U.S. government to earn a fixed amount or fixed rate of interest. The interest is tax-free when used for qualified college expenses. They historically yield a low rate of return, but if purchased for a young child, they provide a safe, guaranteed return once college rolls around.

Custodial Account

A custodial account is opened in the child's name and is governed by the Uniform Gift to Minors Act. Earnings up to a certain limit are taxed at the child's lower rate until age 18 or until age 24 if the child is a full-time student. The child assumes full control of the money at age 18. These accounts are counted as a student asset, thus reducing financial aid eligibility. Parents may not transfer the account to themselves, but they may transfer the account assets to a 529 plan with no penalty.

Life Insurance

A variable life insurance policy can be used as a tax-deferred, long-term savings account. Funds can be used for any purpose, including college. Withdrawals are tax-free and the value of the policy is sheltered from financial need calculations. However, commission fees and premiums can significantly reduce investment gains. And if you change your mind, closing the account early in the child's life incurs serious penalty fees.

Bank Savings Account

Everyone is familiar with old-fashioned bank savings accounts, which the government guarantees up to a certain limit. Unfortunately, such accounts don't earn much interest and may not be the best choice for a long-term college savings plan.

Before You Go Further

These methods have been used successfully by many families, but they may not be relevant in your case, so seek the advice of an experienced college financial advisor—perhaps your accountant or financial planner—to help you choose the optimal investments for you.

College Investment Tips

Invest according to the child's age. Investing in riskier, high-growth funds may be appropriate early in the child's life. But risk should be greatly reduced by the time the child is 14.

Be careful about investing in the child's name. Investment income over $2,000 in a child's account is taxed at the parents' rate. In financial aid formulas, accounts in the child's name are counted at almost four times the rate of accounts held by parents.