#3: State Prepaid Tuition Plans

Another savings option to consider is a state-sponsored prepaid plan. These plans fell from grace because their returns were modest in the late 1990s compared with the booming stock market, but in the early part of this century when we were in a bear market, they beat many mutual funds with an average return of about 5% a year.

These prepaid plans are meant to rise in value at approximately the same rate as state university tuition. Here's how they work: You make payments based on your child's age, and the state invests the money. The money and earnings grow tax-deferred at the federal level, although once again, state laws vary as to whether the earnings are taxed. When it comes time to go to college, the state covers your tuition bill up to the average tuition price at a state public college.

There are some important limitations:

• While you are not locked into going to a state school, if your son or daughter goes to a private college, you'll have to foot the bill for the difference.
• You can invest only until your child reaches the ninth grade. But some plans allow you to switch to a 529 Plan.

Dolan Smart Money Move: Here's a strategy to consider: If your state offers it, start a prepaid plan now. When the market rises, switch to a 529 savings plan. Or if it looks as if you're going to need financial aid, you can roll the prepaid plan over into a 529.

For a list of prepaid plans in each state, go to the National Association of Student Financial Aid Administration Web site, at www.nasfaa.org.

How to Invest Your College Dollars

Once you've decided which plan (or plans) you want to take advantage of, you'll need to decide how to invest the money you're setting aside to pay for college. Here are our guidelines for managing your money smartly:

Up to age 13: You have time to ride out market downturns, so you should go for aggressive growth in these early years. But watch the market and don't stake your child's future to a "hot" sector that could fall through the floor in a few years. If putting 100% in stocks makes you nervous–and it makes just about everyone nervous in a bear market–you can put up to half of the money in fixed-income investments: bonds or bond funds.

Ages 14 - 17: Fourteen should be the watershed age for reassessing what you're doing with your college funds. If you've been extremely aggressive right up until then, it's time to start going into much safer investments. Each year increase the bond funds with the best track record and underweight stock funds. Don't do what one of our listeners did. Back in 2000 she called and said she wished she had listened to us when we said the market was overextended and people should start getting out of equities. She left her child's entire college fund invested in equity mutual funds and lost two years of tuition money.

Age 18: Play it safe from here on, with 100% of the fund in fixed-income investments. That's money market funds, CDs, short-term bond funds, or a combination of the three.

We know you don't want to make any mistakes when it comes to paying for your child's education, so we hope you've found these guidelines helpful. We recommend that you learn your state laws, then choose your plan for yourself and make your own cautious investment decisions. You'll save a lot in commissions if you do. But even if you decide to go with a professional, you'll still be in control of your child's future.

By the way, our favorite book on college financial aid is "Paying for College Without Going Broke," by our good friend Kal Chaney. It's well worth reading.

Learn more about saving for college here.

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