As last year’s financial crash has proven, planning on high returns from market-invested college funds is far from a sure thing.

With the volatile market continuing to batter college savings plans, a number of savings & loans have begun rolling out incentives to save the “old fashioned way”, according to USA Today.

The article points to a number of examples, including a $1,000 bonus that Citizens Bank is offering to those who open a college savings account before their child turns six. It’s a sweet deal: If customers deposit at least $25 per month every year, then the $1,000 bonus, plus interest, will be paid when the child turns 18.

While savings accounts are generally not the best place to save for college — there just isn’t enough compounding interest to get any leverage on the skyrocketing costs of tuition — this particular deal is worth a closer look.

Let’s say you open the account right before your child turns 6. That leaves you 13 years — or 156 months — to deposit $25/month. If you were to stick to that minimum, you would put aside a total of $3900 over those 13 years. On which you would earn $1,000 — a whopping 25.65% interest rate! Pretty impressive. (Of course, if you deposit more than $25 per month, or if start saving earlier in your child’s life, then the returns diminish.)

If you are interested in getting in on this deal, you will need to live in one of the nine states that the bank has branches: Connecticut, Delaware, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, and Vermont. Here’s more information for those of you living in the Northeast. And for the rest of you, come learn more about the best ways to save for college from my series comparing the various tax-advantaged college savings vehicles.

Originally, the plan let investors withdraw their funds, plus earnings, even if the designated beneficiary wasn’t going to college in Texas. Now, however, the state of Texas is amending that benefit: If investors don’t use their plan to pay for school in Texas, they get only the value of their original investment, without any of the interest.

What gives? Apparently, the longhorn plan is running in the red, to the tune of almost $2 billion by 2030. The Texas Legislature deregulated tuition rates in 2003, and that’s when tuition started to skyrocket — much faster than the fund could keep up with. Anticipating this problem, the pre-paid tuition fund was closed to new enrollees in 2003. But the fast-paced rate of tuition inflation has averaged 8.9% a year, while return on investment has been just 4.4%.

Texas is giving families until the end of November to withdraw funds with the interest still attached; after that date, the policy will be changed. While this particular crisis is unique to Texas, I thought the article had national value for anyone investing in — or considering investing in — a 529 pre-paid tuition plan.

First off, as Savingforcollege.com founder Joe Hurley says in this article, the Texas situation is setting a precedent:

This is the first time I can recall that a 529 plan has gone back on its promises in a big way.

More so, however, the pre-paid short-fall is a good opportunity for us to revisit the difference between the two types of 529 Plans.

There are 529 pre-paid tuition plans, like this one in Texas, which allow parents to buy x number of future semesters of tuition at the in-state university at today’s cost.

Then there are 529 college savings plans, which are an investment vehicle for saving money for future college expenses. Your return on a college savings plans is dependent on the type of investment vehicle you choose and how the market does.

To learn more about 529 Plans, check out some of these articles on the Financial Aid Finder:

• Understanding College Savings Plans

• Are 529 Plans still a good plan?

• Choosing a 529 Plan that’s right for your family

529 Plans allow you to contribute after-tax dollars, which then grow tax-free until withdrawal, as long as they are used for qualified education purposes.

(To learn more about 529 Plans, see Financial Aid Finder’s extensive section on College Savings and Prepaid Plans.)

According to the Treasury Department, only 5% of middle-income Americans take advantage of these plans, despite their lucrative tax benefits. Among high-income filers, however, one in three have a 529 account. The College Savings Plan Network reports that there are some 11 million 529 accounts to date, with more than $100 billion in assets.

The Obama Administration’s task force on middle class college saving has recommended a series of changes, including:

• Making contribution limits uniform in all states to stamp out potential abuses

• Creating uniform reporting standards so that it’s easier to compare plans

• Requiring all states to offer at least one low-cost, low-maintenance plan based on index funds

• Requiring states to eliminate the “home state bias” in not offering tax deductions/credits to those who invest in another state’s 529 Plan (If you live in Arizona, Kansas, Maine or Pennsylvania, you already are allowed to claim a deduction regardless of which state plan you contribute to.)

Many experts think the president’s plan doesn’t go far enough, and want to see states required to offer matching grants to families below a certain income level (some states already do this) and want 529 assets to be completely exempted from financial aid calculations.

I’ll tell you from my perspective, I would also like to see the plans become less restrictive in terms of “qualified education expenses”.

You see, I’ve lived and studied abroad and want my children to have that option, as well. But 529 Plans are pretty limiting in terms of where you can use the assets to study. Yes, some plans allow you to study outside the U.S., but it must be at a foreign institution that has U.S. accreditation. My hesitation over this restriction has actually caused me not to invest in a 529, despite the amazing tax benefits.

What about you? Are you currently invested in a 529? Why — or why not? Would any of the President’s current proposals sway you toward investment if you aren’t currently?

• Interest rates on subsidized Stafford loans are dropping — This year, they will go from a 6% to 5.6% (fixed). Under the College Cost Reduction and Access Act of ‘07, the rate will continue to drop until 2011-2012, when it will reach an all-time low of 3.4%. Unfortunately, the lower rate only applies to loans taken out — or consolidated — in that academic year. Remember, with a subsidized loan, the federal government pays your interest while you are in school.

• Income-based loan repayment — I won’t bother rehashing the details, since I’ve covered them extensively in earlier posts. Bottom line is this: If you qualify, you will save a bundle every month.

• The Pell Grant is increasing — The maximum annual amount will increase next fall from $4,731 to $5,350. If your family earns less than $50,000 per year, you likely qualify for the Pell Grant, so be sure to complete your FAFSA (Free Application for Federal Student Aid).

What do you do if federal student aid is still not enough to help you cover your education costs? It’s time to expand your search for scholarships. Don’t forget to check out our weekly Scholarship Announcement post every Friday. And now you can get even more information on specialized scholarships through our brand new Student Scholarship Search page. Check it out today!

It was good to see that staying in school is still a priority for the two families featured in the piece, but rather heart-wrenching to read the real life stats.

For example, did you know that, across the board, the value of savings in 529 Plans has dropped 21% over the past year? And the market drop isn’t just hitting parents who were saving for their kids’ future. It is also hitting universities and their endowment plans, which are a major source of funding for university-based aid like scholarships and tuition reductions.

The article cites that Harvard University alone lost $8 billion in the past year. (Bear in mind that Harvard has the largest endowment of any university in the United States — often cited as worth more than the GDP of many developing nations!).

So how are families coping with job loss/possible job loss, slashed college savings plans, and rising tuition rates? Here are some of the ways:

• Downgrading — Students that were considering elite private schools, with $50,000+ yearly costs, are now applying to in-state four-year colleges. Would-be four-year college students are instead applying to local junior colleges.

• Taking out unplanned student or parent loans — Some families with slashed 529 Plans (or other college savings vehicles) are taking out PLUS loans or Stafford loans for the earlier years of college, in the hopes that their 529 account will rebound in time to pay them off.

• Delaying contributions to 401Ks and other retirement plans — Some parents are choosing to put off saving for their own retirement in order to help cash flow their kids’ college education today. This seems like a risky proposition to me. I can certainly see the immediate benefit and appeal (your kid gets to finish school), but the loss of compounded interest means that your nest egg could be taking a serious hit. Of course, given the current state of the market, maybe families feel like the potential (likely?) negative interest rates isn’t worth stopping their child’s education.

• Bulking up on cheaper college credits — If your college lets you transfer in credits, you can take courses at your local community college during the summer for a fraction of the cost. You might also want to consider giving yourself a head start by taking as many AP classes as possible. (Did you know that many universities will give you credit for AP classes?)

• Asking the financial aid office to reconsider your aid award –  If you or your parent has recently lost a job, incurred unexpected medical expenses, or experience another financial hardship, you are in a good position to ask your school for more assistance. They might not always be able to help you, but it never hurts to ask.

• Applying for as many private scholarships as you can find — Spending just 5-10 hours a week applying for scholarships can net big results. Even if you only win $500 scholarships, a handful of those can add up to more than half your annual tuition bill. (Check out our weekly Scholarship Announcements posts for an up-to-date list of pending scholarship deadlines.)

• Availing yourself of tax credits — Congress signed new tax legislation in February, which included the American Opportunity tax credit. The new credit increased the tax credit for educational expenses to $2,500, and made it available to families for four years, rather than just two. (See Tax Credits and Deductions for Students for more information about this and other credits.)

Have you found a creative way to finance your or your child’s college education? Tell us about it in the comments section (legal ideas only please ;-)).

There’s a whole range of responses to this question, from:

Absolutely not! I paid my own way through school and my kids will do the same! It builds character.

to

100% yes! That’s part of a parent’s responsibility to his or her kids!

Of course, if you ask the students, you will get another range of responses.

And truthfully, I think it’s probably impossible to completely take money out of the equation. After all, it’s one thing for a family of millionaires to pay for college costs. It’s another thing for a cash-strapped family of four earning the median national salary (typically quoted somewhere between $43,000 and $48,000 per year) to find the wiggle room to pay for college. Even still, some families in the latter situation would sacrifice vacations and skrimp on new clothes just to be able to put aside some small amount for college. While other families would simply hope for the best (aka, a generous financial aid package).

In reality, most families — whether for financial reasons or philosophical ones – — end up somewhere in the middle. Parents assist with the cost of college to a certain extent, and then expect their children to step up and cover the rest. Covering the rest might mean applying for and winning scholarships, working full- or part-time during the year and over the summer, picking a less expensive college to begin with, or living and eating at home.

For example, let’s say your parents had managed to save up $20,000 for your college education. Whether that money was easy or hard for them to come by, it surely sounds like a nice sum of money. And it is. In fact, you might even have some spare change left… if you attend a local community college, live at home, and work full-time every summer.

On the other hand, that 20 grand won’t even cover a year’s worth of tuition, room and board at most out-of-state public schools, let alone private schools. Unless, of course, you win a ton of college scholarships.

So, even if your parents’ intention is to cover all of your educational costs for four years, that $20K would have to be used very frugally to actually stretch that far. In other words, getting into Harvard is one thing; paying for it is another.  Especially if you don’t want to graduate with a mountain of student loan debt.

Which raises another question: Should parents cosign a loan for their children? I’ll tell you my personal opinion tomorrow, but I’d love to hear with you think. Is co-signing with your child for a student loan helping them? Or is it hindering? Sound off in our comments section — I’m eager to read your thoughts!

If you aren’t familiar with College Savings Plans, I recently reviewed them in our “Best Ways to Save for College” series — check it out here. Or you can read a more in-depth analysis of 529 Plans in our section on College Savings.

While the past year was abysmal, at best, for mutual funds, there were still a few super stars — and a few super flops — among the 529 Plans, according to Consumer Reports. The magazine compared the plans based on three factors: investment flexibility, low expenses and fees, and 2008 performance. They also looked for plans that were appropriately tracked to decrease the level of investment aggressiveness in the three years before college.

The 5 Best 529 Plans in 2008

Each of these plans is direct-sold, which saves you significantly on fees and expenses.
1. Georgia’s Path2College 529 Plan
2. Iowa’s College Savings Iowa through Vanguard
3. Illinois’ Bright Start College Savings Program through Oppenheimer Funds
4. Mississippi’s Affordable College Savings Program through TIAA-CREF TFI
5. Colorado’s Direct Portfolio College Savings Plan, also through Vanguard

The 5 Worst 529 Plans in 2008

As for the worst funds, these five are all broker-sold, which tends to increase fees and expenses, thereby decreasing performance.
1. Wisconsin’s Tomorrow’s Scholar through Wells Fargo Funds
2. Arkansas’ John Hancock Freedom through T. Rowe Price
3. New Jersey’s Franklin Templeton through Franklin Templeton
4. New York’s Columbia New York Advisor through Columbia Management
5. Nevada’s Columbia 529 Plan through Columbia Management

To see how Morningstar ranked the 529 field for 2008, check out this Finder article on the Best & Worst 529 Plans of ‘08.

And don’t forget… When you are comparing 529 Plans, remember to consider the potential tax savings of investing in your own state’s plan. If you can get an income tax deduction from your state for investing in its plan, consider that plan first. And if you are a resident of Arizona, Kansas, Maine or Pennsylvania, you can get a deduction regardless of which state plan you contribute to — even better! (Here is a complete list of deduction limits by state.)

** Hat tip to 5CentNickel for his earlier review of the Consumer Reports list.

So far we have covered three out of the four: 529 College Savings Plans, 529 Prepaid Tuition Plans, and the Coverdell Educational Savings Account. Be sure to review those posts, if you didn’t get a chance to read them yet.

Today we are rounding out the series with the least well known of your tax-preferred college savings options, the Uniform Gift to Minor/Uniform Transfer to Minor Act.  In short, UGMA and UTMA are custodial accounts that allow you to save a substantial amount of money in your child’s name for the purpose of college… or anything else… while benefiting from your child’s lower tax bracket.

(By the way, I keep emphasizing “tax preferred” because, of course, you are welcome to save for college in a regular old savings account, or a CD or a mutual fund. The thing is, you won’t get any tax savings. If you use one of the four vehicles we covered here, however, you will. And saving on taxes means more money to save for college!)

UGMA/UTMA

What is it: A simple transfer of assets into your child’s name, which he or she can use for educational expenses upon the age of maturity. The assets can be anything worth money — cash, CDs, mutual funds, or even real estate.

Pros: High contribution limit per beneficiary — $13,000 per year for single filers or $26,000 per year for joint filers; no income restrictions on contributions; anyone can contribute to account; first $900 in annual earnings are tax-free

Cons: Originally contributor has no financial control once the beneficiary reaches the age of majority; ownership cannot be transferred as it is considered an irrevocable gift

Bottom line: Once the only tax-advantaged way to save for college, the UGMA/UTMA has fallen out of favor now that 529 Plans and ESAs offer more financial control, more flexibility and better tax savings.

Want to know more? We recently updated the Financial Aid Finders section on Saving for College to include an in depth review of the UGMA/UTMA accounts, covering frequently asked questions such as “Do my earnings grow interest-free, like in a 529 Plan?” and “How will the money I set aside in a UGMA/UTMA affect my child’s financial aid award?”

So tell us: Are you currently investing in a tax-advantaged college savings vehicle? Which one did you choose and why?

If you didn’t catch them last week, start there.

Today we are looking at a lesser known college savings vehicle: the Coverdell Educational Savings Account, also referred to as the Educational IRA. Once the way to save for college, the ESA fell out of favor in 2002 when the 529 Plan came to the fore. The ESA still has a lot of advantages, however, and you should definitely consider it when making your college savings plan.

What is it: An Education IRA — like the Roth IRA, but for college instead of retirement. Allows you to invest up to $2,000 per year per child with tax-free earnings and withdrawals.

Pros: Earnings and qualified withdrawals are tax-free; funds may be used for educational expenses in K-12, as well as for higher education; beneficiary of account can be transferred up to age 30

Cons: Contribution is limited to $2,000 per year per beneficiary; income limits for depositing funds; age limits for withdrawing funds; account is considered parental asset on FAFSA, so it doesn’t have overly negative impact on financial aid award

Bottom Line: A good choice for those of you with private school tuition for your little ones, but otherwise less attractive than the 529 College Savings Plan.

Want to know more? We recently updated the Financial Aid Finders section on Saving for College with an in depth review of the Coverdell ESA. If you are not sure whether to go with the ESA vs. the 529 Plan, check out this comparison between the two. And remember, there’s no law against investing in both of them!

Today we are looking at the other type of 529 Plan — the prepaid tuition plan. (By the way, if you want to know why there are two different plans, both called 529s, check out this article on the difference between College Savings and Prepaid Plans.)

529 Prepaid Tuition Plans

What is it: A savings vehicle that allows you to lock in future tuition payments at today’s in-state rates.

Pros: “Guaranteed” return on your investment; money can be applied to tuition at out-of-state schools (although it obviously won’t cover as much); many states now offer tax deductions for investors; account is considered parental asset on FAFSA, so it doesn’t have overly negative impact on financial aid award.

Cons: Limited to the plans in your state of residence; lower potential gains than with college savings plan, since tuition only increases an average of 7%, while the stock market has historically gained 10-12% over a ten-year span (of course, given the state of the market, those who opted for the more conservative tuition plans over mutual fund-invested college savings plans look like geniuses right now!)

Bottom Line: Investigate your state’s plan carefully before picking this less flexible option.

So what do you think? Which 529 Plan sounds better to you: the college savings or the prepaid tuition? Stay tuned next week when I discuss the Coverdell ESA.