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Last Sunday, I wrote that figuring out which type of college savings plan is best for your family is close to rocket science.

Today, the masochist in me will attempt to explain the main points to consider when choosing among state-sponsored 529 plans, Coverdell and custodial accounts and none of the above.

Our government has made the rules surrounding college savings and financial aid so complex you need an accounting degree to understand them. If you can comprehend them, choosing the "right" plan depends on factors that are hard to predict, such as your income and assets when your child starts school, what type of college (if any) he or she will choose and the tax and financial aid laws in effect then.

There are many good paperback books and Web sites devoted to the topic, but they quickly become dated because the rules change so much. A good one is www.finaid.com/savings.

Many parents are afraid to save for college because they think it will hurt their child's chance of getting financial aid. It might, but not as much as you think. The federal financial-aid formula looks at a family's income and assets, how many children are in college and the older parent's age, to come up with the family's "expected contribution." (If the parents are divorced, the formula uses the custodial parent's assets and income.)

Many parents' eyes pop out when they see how much they are expected to pay. The difference, if any, between their expected contribution and the cost of a particular college will be offered in a financial aid package. The package usually includes grants, student jobs and/or loans. Lower- income families will get more in grants and jobs, more-affluent families will get more in loans. Some loans are not even considered financial aid because they're no better than what parents could get elsewhere.

Colleges use the federal formula to allocate federal grants and most state financial aid. Colleges use the federal and/or their own formulas to dole out institutional aid from their own resources.

If you save nothing but have a substantial income, your child could get no aid, because the formula weights income more heavily than assets. The federal formula expects parents to contribute 22 to 47 percent of income, but only 2.6 to 5.6 percent of assets per year. On the other hand, if you have a modest income, you could have substantial assets and still qualify for aid because many assets are excluded from the need formula.

The federal formula excludes from the family's expected contribution parental retirement assets -- such as IRAs and 401(k) plans -- and the equity in a primary residence. The federal formula also excludes a certain amount of assets for the parents to live on after they have finished putting their kids through college. This "asset protection allowance" is based on the number of parents and the age of the older one. If there are two parents, this allowance ranges from $42,000 if the older parent is 45, to $63,000 if the older one is 60. Many private colleges include home equity and retirement assets in their needs assessment, but may provide an asset protection allowance.

If you don't qualify for need-based aid, your student may qualify for a merit or athletic scholarship, but don't count on it.

According to Finaid.com, "Four-fifths of parents expect that their children will receive scholarships, but only about 7 percent of students actually receive private-sector scholarships." The average undergraduate scholarship is only $2,000 and will often reduce need-based aid packages.

Estimating aid

Although it is difficult to generalize, "If you are making under $60,000 or $70,000 a year, you have a high probability of getting financial aid," says Ray Loewe, president of College Money. If you're in this range, first contribute to your retirement plans -- at least enough to maximize your employer's matching contribution -- before worrying about college savings, Loewe says If you can save more, do it simply, in a savings account, savings bonds or certificates of deposit, says David Braverman, author of Standard & Poor's Guide to Saving and Investing for College. At the other extreme, families with incomes over $150,000 are not likely to get aid, unless they have multiple kids in college at the same time, Lowe says. Families who are in between should save for college in a way that is least likely to reduce financial aid.

Although your financial situation and aid formulas will change over time, assume that if you would qualify for aid today, you'll probably qualify when your child is ready for college, "unless you're on a fast track where your income is skyrocketing," says Loewe.

Braverman says parents should use an online financial aid calculator to estimate their personal chance of getting assistance. He likes the calculators at www.finaid.com/calculators and www.collegeboard.com/pay.

"Do this once a year, so you can make midcourse corrections," he adds.

The main reasons for setting up a college savings account, as opposed to a regular account, are to reduce taxes and keep college funds separate from grocery, vacation and leaky-roof money. What you may give up are flexibility, control and some financial aid.

Custodial accounts

The oldest way to save for college is in a Uniform Gift to Minors Act or Uniform Transfer to Minors Act account. You can open one at almost any bank, brokerage or mutual fund company, and invest the money almost any way you want. The account is in the child's name and Social Security number, with a parent or other adult as custodian until the child reaches age 18 or 21 (depending on the state and type of account.) The money is taxed at the child's rate, with one exception.

In 2004, a child can have $800 of unearned income (from investments) tax free. The next $800 is taxed at the child's rate, which is typically 10 percent. Anything more than $1,600 is taxed at the parents' rate until the child turns 14, and at the child's rate after age 14.

Once you put money in, it remains the property of the child, although you can spend it on things that benefit the child, such as orthodontia or summer camp (but not food or clothing). When the child turns 18 or 21, he or she can use it for college, a car or cocaine. Some parents like that flexibility (except for the cocaine part). Others consider it a huge risk.

The biggest downside is that account is the child's asset in the financial aid formula. The federal formula expects students to contribute 50 percent of their income over roughly $2,400 per year and 35 percent of their assets each year to their educational expenses. The formula assesses parental assets at a top rate of only 5.6 percent, so putting money in the child's name could reduce financial aid for middle- income families. Some experts say the flexibility and tax benefits of a custodial account do not outweigh the loss of control and financial aid impact.

Loewe says there's no reason to open a custodial accounts "unless you're trying to protect college money from creditors."

Others disagree. Kevin Simme, a financial aid consultant in

Princeton, N. J., continues to favor custodial accounts because of their flexibility. He says many private colleges are abandoning the distinction between "parent" and "child" assets and lumping them into "family" assets, reducing the disadvantage of custodial accounts.

Other options

Two newer options are the Coverdell Education Savings Account (formerly the Education IRA) and the 529 plan. In both types of accounts, you get no tax deduction for money you put in, but earnings grow tax-free. Under current law, earnings remain tax-free when you take them out if they are used for qualified college expenses, which include tuition, room and board, books and even computers. This provision expires in 2010. Most people think it will be extended, but if it is not, beginning in 2011, account earnings will be subject to income tax when they are withdrawn. If you take money out of a 529 or Coverdell for non-education expenses, you will owe income tax a 10 percent penalty on the earnings portion.

Now for the differences between the two plans:

Coverdell accounts

You can open a Coverdell at almost any financial institution that offers IRAs. You can invest the money in almost any stocks, bonds, mutual funds or savings vehicles. Some firms charge an annual maintenance fee. A child younger than 18 must be named as the beneficiary of the account, with an adult as the responsible individual. The money is an irrevocable gift to the child and must be used by age 30. If it's not, the money will be distributed to the beneficiary and the earnings will be subject to income tax plus a 10 percent penalty.

The maximum contribution to a Coverdell from all sources combined is $2, 000 per beneficiary per year. Your maximum annual contribution will be reduced if your income is more than $190,000 (married couples) or $95,000 (single filers). Your contribution is zero if you make more than $220,000 (married) or $110,000 (single). You can get around these income limits by first giving money to the child, and letting him or her put it in the Coverdell. Unlike a 529 plan, the money in a Coverdell can be withdrawn tax-free to pay for elementary and high-school education expenses, such as private-school tuition.

529 plans

Every state except Washington sponsors at least one 529 plan. You can invest in any state's plan, although many states offer residents a tax deduction or matching contribution if they invest in their home-state plan. California offers no such incentive.

A 529 plan is usually run by a mutual fund company and offers just five to 10 investment options. This is a drawback if you like to actively manage money, but it might be a benefit if you don't. The quality and cost of 529 plans vary. (For the best and worst plans, see my Feb. 15 column at www.sfgate.com.)

Any person can contribute to a 529 plan, regardless of income, and you can contribute a lot. California's Scholarshare plan lets you accumulate up to $275,000 per beneficiary. You can open a 529 plan in the name of the parent or the child, with differing impacts on financial aid.

Financial aid impact

The U.S. Department of Education last month attempted to clarify how Coverdell and 529 plan accounts will be treated in the federal financial aid formula. In a "Dear Colleague" letter, it said Coverdell and 529 accounts "receive equal treatment in the calculation of federal financial aid eligibility. Specifically, both can be regarded as assets of the parent if the parent is the owner of the account, rather than the student, and thereby displace a smaller amount of financial aid."

This "clarification" has created a lot of confusion. Although a 529 plan can clearly be owned by either the parent or the child, it's not clear who "owns" a Coverdell account. Joseph Hurley, who runs www.savingforcollege.com, interpreted the letter to mean that a Coverdell could be considered a parent asset. The Education Department "harbors the misconception that a parent can 'own' (a Coverdell account). It just doesn't work that way. Regardless, it's good news for families using" Coverdells," he wrote.

However, several other financial aid experts I spoke to insisted that the Coverdell is a student asset. So I called the Education Department to set the record straight. Unfortunately, Dan Madzelan, a director in the office of postsecondary education, said the department can not say who owns a Coverdell. "As with other assets, the parent makes the best determination of the net value and other determinations about who has control of or otherwise owns the asset," he says.

Private schools may count Coverdell and 529 accounts as a student, parent or "family" asset, depending on the institution.

College savings can complicate tax filing. When your child gets to college, there are several tax deductions and credits you may be able to claim for out-of-pocket higher-ed expenses, if your income is not too high and the laws have not changed.

You cannot, however, claim a tax credit or deduction for expenses paid for with money you took out of a Coverdell or 529 plan to pay for college.

	Ins and Outs of Saving for College By Kathleen Pender of the San Francisco Chronicle Febuary 22, 2004


	Last Sunday, I wrote that figuring out which type of college savings plan is best for your family is close to rocket science. Today, the masochist in me will attempt to explain the main points to consider when choosing among state-sponsored 529 plans, Coverdell and custodial accounts and none of the above. Our government has made the rules surrounding college savings and financial aid so complex you need an accounting degree to understand them. If you can comprehend them, choosing the "right" plan depends on factors that are hard to predict, such as your income and assets when your child starts school, what type of college (if any) he or she will choose and the tax and financial aid laws in effect then. There are many good paperback books and Web sites devoted to the topic, but they quickly become dated because the rules change so much. A good one is www.finaid.com/savings. Many parents are afraid to save for college because they think it will hurt their child's chance of getting financial aid. It might, but not as much as you think. The federal financial-aid formula looks at a family's income and assets, how many children are in college and the older parent's age, to come up with the family's "expected contribution." (If the parents are divorced, the formula uses the custodial parent's assets and income.) Many parents' eyes pop out when they see how much they are expected to pay. The difference, if any, between their expected contribution and the cost of a particular college will be offered in a financial aid package. The package usually includes grants, student jobs and/or loans. Lower- income families will get more in grants and jobs, more-affluent families will get more in loans. Some loans are not even considered financial aid because they're no better than what parents could get elsewhere. Colleges use the federal formula to allocate federal grants and most state financial aid. Colleges use the federal and/or their own formulas to dole out institutional aid from their own resources. If you save nothing but have a substantial income, your child could get no aid, because the formula weights income more heavily than assets. The federal formula expects parents to contribute 22 to 47 percent of income, but only 2.6 to 5.6 percent of assets per year. On the other hand, if you have a modest income, you could have substantial assets and still qualify for aid because many assets are excluded from the need formula. The federal formula excludes from the family's expected contribution parental retirement assets -- such as IRAs and 401(k) plans -- and the equity in a primary residence. The federal formula also excludes a certain amount of assets for the parents to live on after they have finished putting their kids through college. This "asset protection allowance" is based on the number of parents and the age of the older one. If there are two parents, this allowance ranges from $42,000 if the older parent is 45, to $63,000 if the older one is 60. Many private colleges include home equity and retirement assets in their needs assessment, but may provide an asset protection allowance. If you don't qualify for need-based aid, your student may qualify for a merit or athletic scholarship, but don't count on it. According to Finaid.com, "Four-fifths of parents expect that their children will receive scholarships, but only about 7 percent of students actually receive private-sector scholarships." The average undergraduate scholarship is only $2,000 and will often reduce need-based aid packages. Estimating aid Although it is difficult to generalize, "If you are making under $60,000 or $70,000 a year, you have a high probability of getting financial aid," says Ray Loewe, president of College Money. If you're in this range, first contribute to your retirement plans -- at least enough to maximize your employer's matching contribution -- before worrying about college savings, Loewe says If you can save more, do it simply, in a savings account, savings bonds or certificates of deposit, says David Braverman, author of Standard & Poor's Guide to Saving and Investing for College. At the other extreme, families with incomes over $150,000 are not likely to get aid, unless they have multiple kids in college at the same time, Lowe says. Families who are in between should save for college in a way that is least likely to reduce financial aid. Although your financial situation and aid formulas will change over time, assume that if you would qualify for aid today, you'll probably qualify when your child is ready for college, "unless you're on a fast track where your income is skyrocketing," says Loewe. Braverman says parents should use an online financial aid calculator to estimate their personal chance of getting assistance. He likes the calculators at www.finaid.com/calculators and www.collegeboard.com/pay. "Do this once a year, so you can make midcourse corrections," he adds. The main reasons for setting up a college savings account, as opposed to a regular account, are to reduce taxes and keep college funds separate from grocery, vacation and leaky-roof money. What you may give up are flexibility, control and some financial aid. Custodial accounts The oldest way to save for college is in a Uniform Gift to Minors Act or Uniform Transfer to Minors Act account. You can open one at almost any bank, brokerage or mutual fund company, and invest the money almost any way you want. The account is in the child's name and Social Security number, with a parent or other adult as custodian until the child reaches age 18 or 21 (depending on the state and type of account.) The money is taxed at the child's rate, with one exception. In 2004, a child can have $800 of unearned income (from investments) tax free. The next $800 is taxed at the child's rate, which is typically 10 percent. Anything more than $1,600 is taxed at the parents' rate until the child turns 14, and at the child's rate after age 14. Once you put money in, it remains the property of the child, although you can spend it on things that benefit the child, such as orthodontia or summer camp (but not food or clothing). When the child turns 18 or 21, he or she can use it for college, a car or cocaine. Some parents like that flexibility (except for the cocaine part). Others consider it a huge risk. The biggest downside is that account is the child's asset in the financial aid formula. The federal formula expects students to contribute 50 percent of their income over roughly $2,400 per year and 35 percent of their assets each year to their educational expenses. The formula assesses parental assets at a top rate of only 5.6 percent, so putting money in the child's name could reduce financial aid for middle- income families. Some experts say the flexibility and tax benefits of a custodial account do not outweigh the loss of control and financial aid impact. Loewe says there's no reason to open a custodial accounts "unless you're trying to protect college money from creditors." Others disagree. Kevin Simme, a financial aid consultant in Princeton, N. J., continues to favor custodial accounts because of their flexibility. He says many private colleges are abandoning the distinction between "parent" and "child" assets and lumping them into "family" assets, reducing the disadvantage of custodial accounts. Other options Two newer options are the Coverdell Education Savings Account (formerly the Education IRA) and the 529 plan. In both types of accounts, you get no tax deduction for money you put in, but earnings grow tax-free. Under current law, earnings remain tax-free when you take them out if they are used for qualified college expenses, which include tuition, room and board, books and even computers. This provision expires in 2010. Most people think it will be extended, but if it is not, beginning in 2011, account earnings will be subject to income tax when they are withdrawn. If you take money out of a 529 or Coverdell for non-education expenses, you will owe income tax a 10 percent penalty on the earnings portion. Now for the differences between the two plans: Coverdell accounts You can open a Coverdell at almost any financial institution that offers IRAs. You can invest the money in almost any stocks, bonds, mutual funds or savings vehicles. Some firms charge an annual maintenance fee. A child younger than 18 must be named as the beneficiary of the account, with an adult as the responsible individual. The money is an irrevocable gift to the child and must be used by age 30. If it's not, the money will be distributed to the beneficiary and the earnings will be subject to income tax plus a 10 percent penalty. The maximum contribution to a Coverdell from all sources combined is $2, 000 per beneficiary per year. Your maximum annual contribution will be reduced if your income is more than $190,000 (married couples) or $95,000 (single filers). Your contribution is zero if you make more than $220,000 (married) or $110,000 (single). You can get around these income limits by first giving money to the child, and letting him or her put it in the Coverdell. Unlike a 529 plan, the money in a Coverdell can be withdrawn tax-free to pay for elementary and high-school education expenses, such as private-school tuition. 529 plans Every state except Washington sponsors at least one 529 plan. You can invest in any state's plan, although many states offer residents a tax deduction or matching contribution if they invest in their home-state plan. California offers no such incentive. A 529 plan is usually run by a mutual fund company and offers just five to 10 investment options. This is a drawback if you like to actively manage money, but it might be a benefit if you don't. The quality and cost of 529 plans vary. (For the best and worst plans, see my Feb. 15 column at www.sfgate.com.) Any person can contribute to a 529 plan, regardless of income, and you can contribute a lot. California's Scholarshare plan lets you accumulate up to $275,000 per beneficiary. You can open a 529 plan in the name of the parent or the child, with differing impacts on financial aid. Financial aid impact The U.S. Department of Education last month attempted to clarify how Coverdell and 529 plan accounts will be treated in the federal financial aid formula. In a "Dear Colleague" letter, it said Coverdell and 529 accounts "receive equal treatment in the calculation of federal financial aid eligibility. Specifically, both can be regarded as assets of the parent if the parent is the owner of the account, rather than the student, and thereby displace a smaller amount of financial aid." This "clarification" has created a lot of confusion. Although a 529 plan can clearly be owned by either the parent or the child, it's not clear who "owns" a Coverdell account. Joseph Hurley, who runs www.savingforcollege.com, interpreted the letter to mean that a Coverdell could be considered a parent asset. The Education Department "harbors the misconception that a parent can 'own' (a Coverdell account). It just doesn't work that way. Regardless, it's good news for families using" Coverdells," he wrote. However, several other financial aid experts I spoke to insisted that the Coverdell is a student asset. So I called the Education Department to set the record straight. Unfortunately, Dan Madzelan, a director in the office of postsecondary education, said the department can not say who owns a Coverdell. "As with other assets, the parent makes the best determination of the net value and other determinations about who has control of or otherwise owns the asset," he says. Private schools may count Coverdell and 529 accounts as a student, parent or "family" asset, depending on the institution. College savings can complicate tax filing. When your child gets to college, there are several tax deductions and credits you may be able to claim for out-of-pocket higher-ed expenses, if your income is not too high and the laws have not changed. You cannot, however, claim a tax credit or deduction for expenses paid for with money you took out of a Coverdell or 529 plan to pay for college.