Higher Education: 529 Plans, Grants, More

Q. Which is better: a prepaid 529 plan or a 529 college savings plan?
—Richard Pralat, Deltona, Fla.

Both offer tax-free savings for certain college costs, and both have struggled lately. Choosing the right one depends partly on your home state and your tolerance for risk.

For most, the college savings plan is more flexible than the prepaid plan. It allows you to invest in a small pool of mutual funds and other investments, and is often run by a big fund company. Over the long haul, this should lead to greater gains than a prepaid plan, but recent history has shown these accounts can suffer substantial losses, too. Contributors don’t need to stick with their state’s plan, but there are often state-tax benefits for doing so.

With a prepaid tuition plan, you pay today for future in-state college bills. The account grows according to the state’s annual public-college tuition increases, which have averaged 4.2 percent over the past decade, and that’s on top of inflation, according to the College Board. Should your student opt for a private or out-of-state school, your account may come up short. A bigger concern is that some plans are struggling to meet obligations. Of the 19 prepaid plans operating, only 12 take new applications. And some of those are hurting, says Joseph Hurley, founder of Savingforcollege.com. Still, the Florida prepaid plan is one of the best, he says, noting its state-backed guarantee.

Despite the recent woes of 529 plans, the tax perks make them a good way to save. But like any other investment, stick with plans with low fees and a risk level you’re comfortable with.

Q. I’d like to use IRA money to pay my son’s college bills. How do I do this?
—Chuck Sarahan, Washington, D.C.

Hang on: Is there any chance you’ll need that money yourself some day? “Don’t jeopardize your retirement,” warns IRA expert Ed Slott, who usually advises using student loans instead of IRA withdrawals.

The IRS does waive the standard 10 percent early-withdrawal penalty (applied to those under age 59½) if the money is used for certain college costs. To take the withdrawal, you’ll fill out a form with your IRA provider and report the distribution on your tax return. You’ll owe ordinary income tax on withdrawals taken from a deductible IRA. With a Roth IRA, taxes are due on earnings.

But that’s a last-case scenario, experts say. “Tapping your IRA early is like slaughtering a golden goose,” Slott says, since the real strength of IRAs is their ability to compound over time.

Q. How can I find free college money for my daughter? We don’t qualify for the Pell Grant.
—Janice Whittaker, Buford, Ga.

Grants and scholarships generally fall into two categories: merit-based and need-based. That doesn’t mean your daughter needs to be a brainiac or that your family needs to be struggling financially, though either would increase your odds.

Dig deep enough and you can find scholarships for some pretty obscure interests and skills. Corporations and other organizations often fund scholarships, as do the states and colleges themselves. Start with online scholarship search engines like FastWeb, says Ben Kaplan, creator of the DVD Finding College Cash in Tough Times, and tap the resources of your high school’s guidance counselor. Colleges award more gift aid to students they really want, so it pays to find the right fit.

For need-based aid, much rides on the Free Application for Federal Student Aid (FAFSA) form, which asks for details on your family’s finances. If you aren’t happy with your package, consider appealing for more aid.