The Smart Way to Save for Your Kid's College

NEW YORK ( TheStreet) -- All over the country, high school seniors are putting on caps and gowns and heading across the stage for that cherished diploma. Next comes college -- and a tricky set of payment issues for students and their parents.

Many families that have worked hard to save for college now have money in multiple pots -- cash in bank savings, 529 plans, a variety of stock and bond mutual funds. Which accounts should be tapped first, and which left for later?

It's hard to know for certain because you can't predict investment returns over the next few years and don't know how much college costs will rise. If stocks soar, it obviously would pay to leave money in stocks and stock mutual funds for as long as possible. But stocks are risky, and you could suffer a big loss if the funds for senior year were kept in stocks and there was a downturn at the last minute.

College savings are needed at a specific time and are spent over a short period, making it very hard to wait out a slump. Retirement savers, in contrast, have more flexibility. They can postpone retirement, trim their budget or work part time to recover from an investing setback.

So it's probably best to hedge your bets with college money and not get too greedy hoping for whopping returns.

Consider, for example, how the pros do it. Mutual fund firms that offer target-date funds for college savings put most the money into stocks when college is years and years off, then switch to short-term bonds and cash as freshman year approaches.

On the other hand, the stock market has been doing well. If you can handle some risk, stocks holdings could grow nicely over the next two or three years.

So here's one option:

Fund the first college year by cashing out the riskiest investments, such as individual stocks, which tend to be more volatile than funds.

If selling the risky assets produces more cash than you need for the coming year, the excess can go into a savings account or money market fund. You might earn a tad more with a one- or two-year certificate of deposit, but yields are so low there's little to gain from tying your money up.

With this strategy, you may still have some stocks in broad-based mutual funds. It would probably make sense to convert those to cash before sophomore or junior year. Again, that's because holding stocks in any form for senior year expenses is just too risky because there would be too little time to handle problems. Watch for a good opportunity to sell over the next year or so to build up your cash well before it will be needed.

Target-date funds can be held in reserve to pay for junior or senior year. If the target date matches the student's freshman year, the fund will be almost entirely invested in cash and short-term bonds. That makes it a safe and reliable funding source for the later college years. But if you have other holdings in stocks, the target funds could be used anytime stocks are in a slump when bills are due -- sophomore year, for example.

What about 529 plans? In these plans, investment gains are tax free if used for college. It might seem best to maximize tax-free compounding by tapping these funds later rather than sooner, but the more important factor is the type of asset in the plan.

If the account is heavy on stocks, it would be safest to convert to cash sooner rather than later, to avoid that risk of a slump. Once the 529 is invested in cash and/or short-term bonds, the tax protection becomes a less important issue, because investment returns are likely to be very small. So you can spend the cash from the 529 whenever it's needed.

No question about it: It's all a juggling act. But the key consideration is clear: With an investing horizon of only a few years, safety is more important than maximizing returns.