One of the biggest economic challenges facing parents today is saving enough money to help put their children through college. Although the task is daunting, it’s not impossible. With careful planning, you may be able to save a sizeable amount of money without any significant tax erosion.

Section 529 plans. These savings plans—named after the applicable tax-code section—have become wildly popular in recent years. The reason: You pay zero federal income tax on the earnings accumulating in a 529 account. Furthermore, you’ll pay no tax on withdrawals used to pay for college tuition, room and board. Section 529 plans are state-sponsored college savings arrangements. The state 529 plan is simply the investment house; students aren’t bound to attend college in that state. So, if you open up a 529 plan in this state, those funds can be used tax-free to pay for a child’s schooling in-state or in any other state. (Some states do offer state income tax incentives to encourage residents to contribute to their state’s 529 plan.)

After choosing a state plan, you start by establishing a 529 account designated for a beneficiary, such as your child or grandchild. You can make contributions in large lump-sum payments or by installments over several years. Either way, you can typically contribute at least $100,000 to a 529 plan, and possibly more. State 529 plans offers various investment strategies, including equity mutual funds and more conservative options, such as money market funds. You can change investment options as often as once a year or whenever the beneficiary is changed. Plus, you can switch plans as often as once every 12 months. So, if you decide another state’s 529 plan is better, you can simply roll over the current 529 account balance into the new 529 plan. That triggers no federal tax consequence.

The best part of all: When it’s time to pay the tuition, you can pull money from the 529 account tax-free.

Custodial Accounts. Some people don’t like 529 plans. They may be uncomfortable with the state holding their cash. Or maybe they believe they can earn a higher rate of return by putting college savings dollars into a taxable brokerage account and managing the investments themselves. With the reduced rates on long-term capital gains and dividends, they’ll pay lower taxes on their investment profits. If you decide to take this route, you’ll likely generate better tax results by saving in your child’s name, rather than your own name. Typically, you might set up a custodial account for your college-bound child. Then, you fund the account with cash contributions. The contributions are considered gifts to the child, since he or she is the legal owner of the account. Under the federal gift-tax exclusion, a parent can give up to $12,000 each year into the custodial account without any adverse federal gift- or estate-tax consequences.

Married couples can jointly contribute as much as $24,000 per account each year. The money is invested and taxes are paid at the child’s lower rates. The college fund compounds that much quicker, because the after-tax rate of return is that much higher. Currently, the top federal rate on ordinary income from interest and short-term capital gains is 35 percent while the rate for long-term capital gains and most dividends is only 15 percent. However, parents who save in this manner must be aware of the so-called "kiddie tax." For 2006, that law says that children under age 18 can receive up to $1,700 in investment income (taxed at their low rate), while income over that amount is taxed at the parents’ top marginal tax rate.

Coverdell ESA. For individuals who can only set aside a modest amount each year for college, a Coverdell Education Savings Account (ESA) could be a good alternative. A parent can contribute up to $2,000 each year between now and when a child reaches 18. If you have several children, you can set up separate ESAs for each one. Then, you’re able to contribute up to $2,000 to each account every year. Income and gains from Coverdell ESAs are free of any federal income taxes, as long as withdrawals are used for qualified education costs. The ability to contribute to an ESA is phased out for higher-income taxpayers.