Thanks to a recently passed tax law, the best way for families with young kids to save for college is through a 529 plan, named for the section of the Internal Revenue Code under which the plans were created. These investment accounts -- similar in many ways to a 401(k) -- allow you to put money into mutual funds, where it can grow and compound tax-free. "Then, when it comes time to pay for college, you can use the money, tax-free, for qualified education-related expenses," explains Joseph Hurley, CEO of Savingforcollege.com, a Web site that provides information on investment options. (Another bonus: Money in a 529 plan will not affect a child's eligibility for financial aid when he's in college. Funds in his name in a regular savings account or a trust fund, by contrast, may.)
The 529 plans are offered by 48 states and the District of Columbia, though they are usually run and administered by brokerage firms like Wells Fargo, Vanguard, and T. Rowe Price. No matter where you live, you can invest in any state's plan, though 29 states and the District of Columbia now offer extra tax advantages to their own residents. So be sure to investigate your home state's plan first. (Different plans have varying structures and fees.)
Some states also offer another type of 529 known as a "prepaid tuition plan," which allows you to pay for your child's future education (usually at a state university) at today's prices. Some families swear by these, but there are some potential drawbacks: When your child is in preschool, it's hard to know what the best college for her will be, and this type of savings plan can limit her options. While the plans usually have provisions for transferring the funds to out-of-state or private schools, you may have to pay extra fees to do it.
Also, most prepaid plans only cover tuition -- not room and board, which is usually a big chunk of college fees -- so you probably would need another 529 account to cover those. Talk to a financial advisor to determine what's best for you (make sure it isn't someone who will get a fee for steering you in a specific direction), or go to savingforcollege.com, where there's a tool for comparing various options.
Another tax-free college savings plan that you may have heard about is a Coverdell account. But the Coverdell tax benefits are set to expire in 2010, and at this point it's unclear whether Congress will extend them. So it's a safer bet to go with a 529 plan.