Making the grade.

Do state college tuition plans pass or fail in giving parents huge savings?

Were you to look at a report card on state college savings and prepaid tuition plans--five or even three years ago--it would have been marked with Cs, and in some cases, Ds. But now several states are busy rolling out new programs or upgrading existing ones that are well above average.

What's new? Greater tax breaks. With these "529 investment plans," so named after section 529 in the Taxpayer Relief Act of 1997 and the Small Business Jobs Protection Act of 1996, earnings are federally tax-deferred until withdrawn, and may be free of state tax. When withdrawn, the money is taxed at the student rate--15%--if used to pay college costs, such as room and board, books, supplies and tuition. Proceeds not used for college are taxable at the parents' rate and are subject to a 10% penalty on the earnings.

"529 plans are the best kept secret in college investing," says Abram Claude, a vice president at Fidelity Investments in Boston. "Many parents and even tax experts have overlooked this major tax savings in part because all of the attention was on Roth IRAs," he adds.

With higher education costs increasing by 8% or more a year, 529 plans are gaining widespread popularity. Thirty-four states, including New York, Delaware and Montana, have college savings programs. The number of plans is expected to reach 43 by year's end.

These programs fare slightly better than custodial accounts associated with the Uniform Gift to Minors and Uniform Transfer to Minors regulations, where your child is in charge of the account once he or she becomes of age at 18 or 21. "But with 529 plans, the money belongs to the parent," says Claude. And whereas education IRAs are limited to a maximum annual contribution of $500, 529 programs allow $50,000 or more, plus special gift tax advantages, regardless of the donor's income level.

There are some distinct differences between state-sponsored college savings plans and prepaid tuition plans. Prepayment plans allow parents to lock in today's tuition rates although most have residency requirements and some are restricted to a particular state school.

However, college savings plans offer no guarantees. You make automatic payments to the account and your return depends on who's investing the plan's money. Until recently, most state plans were managed and marketed by state treasuries. Several states have hired mutual fund managers to handle their 529 accounts. New York uses home-based TIAA-CREF (877-697-2837) as its program manager. New Hampshire and Delaware have Fidelity Investments (800-544-1722), and Montana has contracted with College Savings Bank in Princeton, New Jersey (800-888-2723).

So, what happens if your child decides not to go to college or chooses a college out of state? Most 529 plans are portable--they'll pay toward private or out-of-state schools. They also offer a couple of alternatives: parents can transfer the tuition to another child with college aspirations (or even an adult family member returning to college), or they can get back their money. To find out more, call the College Savings Plan Network at 877-277-6496 or tap into www.college savings.org.

"It's important for parents to understand what they're getting," says Peter Roberts, chairman of College Savings Bank. "To work, you need a plan that generates at least a rate of return of 10% (or 20% if you're considering private colleges) in order to stay ahead of rising tuition rates. Otherwise your child's education may end up underfunded."

Treat college savings plans as you would any prospective investment--ask for a prospectus. Who's managing the account and where are the funds invested? For instance, contributions to Montana's program are invested in certificates of deposits indexed to college costs and FDIC insured, guaranteeing your principal and interest.

"Fidelity's plan is tailored to the age of the child," says Claude. "So, the portfolio is heavily weighted in stocks and stock mutual funds when the child is younger but shifted to mainly bonds and money market funds as he or she reaches college to safeguard against changes in the market." He concedes the risk is greater, but so is the potential payoff.