The Gallup organization has reported that 86% of Americans believe a college education will be beyond the reach of most families in the future. It's a subject of almost universal concern among parents. Since 1980, as measured by the consumer price index, college costs have grown 2-21/2 times faster than inflation. Estimates of $150,000-$200,000 are tossed out as the total cost package for getting one child through a good school. Some people may pay that amount, but most can't and you don't have to, either. What follows are some practical tips on tackling what can easily be the single largest expense item of your life.
The first key is to get started now. You want to start early because the amount of time you have available to let the principle of compound interest work for you makes a huge difference in your eventual investment results. The "College Cost Calculator" below dramatically illustrates the importance of getting an early start. For example, if you have 14 years before your youngster goes off to college, you only need to set aside $230 per month in order to build a college fund of $65,800. That $65,800 is expected to represent about 70% of the total bill for four years of college at a public school. That's a reasonable goal, as the American Council on Education says that parents and students now combine to pay about two-thirds of college costs; student aid, either from the school itself or from the taxpayers, pays the remaining third.
On the other hand, if you get off to a late start, your opportunity for compounding is diminished. If, for example, you have just six years remaining until college days arrive for your youngster, you'll need to invest $536 every month in order to accumulate the roughly $48,000 you'll need for the parents' 70% share.
The earlier you begin, the more risk you can take. This means selecting an aggressive portfolio that is initially 100% stocks, and adding short-term bonds or money markets as you get closer to the time when you'll need the money. The state-sponsored 529 plans we'll be talking about later can automate this process for you.
The second key is to let your kids know that paying for college is their responsibility as well as yours. Spending for college is no different than any other purchasing decision. Just as some of us can't afford the most expensive house on the block, in the same way some of us can't afford to foot the bill for an expensive college education. Let your children know how much you will try to contribute toward their college education. If they can find a school for that amount of money, great. If not, it's up to their savings, summer jobs, scholarships, financial aid, and student loans to make up the difference.
To get them started thinking along these lines, it helps to open a college savings account when they're very young. Some families are able to begin when the child is born, either with previous savings or cash gifts received from grandparents. It doesn't have to be a large amount, but opening the account early makes a statement that this is an important expense that must be planned for far in advance. Over the years, the account can be added to with money received for birthdays, earnings from yard work, baby-sitting, and so on.
Chooseing the Right Account
The college savings landscape is dramatically different today than a decade ago. Back then, the most popular vehicles were EE savings bonds and UGMA custodial accounts. The bonds offered tax advantages but were an inferior investment product. The UGMA accounts offered better investing options but had other drawbacks. Changes to the tax laws in 1997 and 2001 have eliminated those tradeoffs for most college savers, allowing them to invest on a tax-free basis without having to settle for either inferior investment products or giving up control of the money invested. Here's a quick overview of the primary college savings account types.
• A Uniform Gifts to Minors Act (UGMA/UTMA) account. This college savings vehicle allows some taxes on investment gains to be paid at the child's lower tax rate. But with new account types available that offer truly tax-free savings, UGMA accounts have fallen out of favor. Some financial planners still like them because of their flexibility ? the eventual use of the funds in the account is not restricted to paying for a college education. But that flexibility has a major drawback because it means essentially giving the money to the child outright. Once money is put into this account, the parent has permanently given up ownership. That means when Junior turns 18 or 21 (depending on your state of residence), it's his call whether he uses the money in the account to buy a Corvette instead of going to college.
• State-sponsored prepaid tuition plans. In general, prepaid state tuition plans promise that your investment in the plan today will cover tuition at any school in the state no matter what the cost at the time your child enrolls. Consider this recent example from Florida's College Prepaid Program: For the enrollment period that just ended, a lump sum payment of $12,899 for a child in the third grade would cover all of the child's future tuition and fees for four years at a state university ? guaranteed. The price is locked in regardless of future increases in state tuition.
Due to the rapid rise of college costs in recent years, some states have either stopped accepting new participants in their prepaid tuition plans, or have made the pricing options less attractive. As a result, fewer parents have access to a compelling prepaid tuition plan. Still, they offer a no-risk alternative to paying for a college education. However, as with most no-risk investments, the internal rate of return typically isn't that great. In addition, there are some limits on how flexible these plans are. If Junior decides to break a five generation tradition and forsake Home State U. (gasp!) in favor of its arch rival in the state next door, the consequences vary from state to state. They may be as dire as having the amount contributed to the plan returned with very little interest, or your state might be generous and give a credit equivalent to what would be paid to an in-state school.
• Coverdell Education Savings Account. Created in 1997 as Education IRAs, and improved dramatically in 2001, Coverdell ESAs are a very compelling savings vehicle for parents who meet the contribution limits. Parents filing jointly with adjusted gross income below $220,000 may contribute up to $2,000 per child, per year, to a Coverdell ESA. The contribution is not deductible, but all earnings grow tax-deferred, to be distributed tax-free if used to pay the beneficiary's college expenses. $2,000 per year may not seem like much, but it adds up if you start early. Contributing $2,000 per year for 18 years with an earnings rate of 10% would accumulate to just over $100,000.
While both Coverdell ESAs and Section 529 plans offer the prospect of potentially tax-free earnings, Coverdell's offer the flexibility to choose the specific investments you desire. Section 529 plans don't, as we'll see shortly. This is a big advantage to using a Coverdell for those who want to direct their own investment program, as many Sound Mind Investing readers no doubt would want to do. (Most fund companies or brokerages can set up a Coverdell ESA for you, allowing you access to their full range of investment products.)
In addition, the favored tax treatment of Coverdell earnings extend to cover elementary and secondary school expenses. The list of qualified expenses is lengthy, and includes both obvious items like tuition and books, as well as non-obvious items like uniforms, transportation, even computers and Internet access for the family during the years the beneficiary is in school.
It's worth noting that contributors are now allowed to contribute to both a Coverdell ESA and Section 529 plan in the same year (although contributions to both types of plans are combined for gift tax purposes). This is great for parents who want to save more than the $2,000 per year allowed in a Coverdell, or for parents who want to save for college in a 529 plan while also saving for elementary and secondary school costs in a Coverdell ESA.
• Section 529 plans. These plans are quickly becoming the savings vehicle of choice for many parents and grandparents. A 529 plan offers the same potential tax-free savings for college as a Coverdell ESA. Most 529 plans are run by individual states, the majority of which make their plans available to any U.S. resident (rather than just residents of their state). This means a great variety of plans are available to today's college saver. Students are not required to attend college in the state where their 529 plan money is invested either; they can use the assets at any accredited post-secondary institution in the U.S.
Unlike Coverdell accounts, there are no annual income limitations for 529 plan contributors, making 529s the natural choice for high-income college savers. In addition, while Coverdell ESAs limit contributions to $2,000 per beneficiary per year (combined from all contributors), with a 529 plan an individual can contribute up to $11,000 per year to a single beneficiary (that limit being the maximum annual gift tax exclusion). There's even a way to boost this already high limit: a contribution of up to $55,000 can be made up front, and treated as five consecutive annual contributions for gift tax purposes. Given that these limits are per contributor, a couple could effectively give double these amounts to a single beneficiary. For most people, this means 529 plans offer them the ability to save as much as they can without worrying about any restrictions.
Don't be dissuaded if you don't happen to have $11,000 laying around to fund a 529 plan with. Even small amounts invested regularly over an extended period of time can grow surprisingly large. For example, if you can save $75 per month for 18 years and the plan averages returns of 10% per year, you'll end up with $45,418. That may not cover all of Junior's college expenses, but it'll sure put a big dent in them.
Most 529 plans are managed by mutual fund companies and offer a range of investment options. Usually, one or more age-based portfolios are available that automatically adjust the percentage of stocks, bonds, and cash in the account according to a preset formula as the child ages. In addition, many states are adding "static" investment choices which allow the contributor to select a certain mutual fund or mix of mutual funds that will remain constant unless the contributor initiates a change. Each state offers a different set of investment choices, making this both a difficult and important area to compare between state plans.
A final advantage of 529 plans is that the contributor retains control and ownership of the account. This is important on several levels. For starters, it means that the contributor can pull money out of the account at any time and for any purpose, although taxes and a 10% penalty will result from unqualified distributions. It also allows for a great deal of flexibility in changing the beneficiary from one child (or grandchild) to another. Having the 529 plan considered as a parental asset is likely to help in financial aid calculations, as student-owned assets count more heavily in the calculations than do parent-owned assets. And perhaps most importantly, it ensures that a child who decides not to go to college doesn't wind up with an unintended financial windfall. A 529 plan may not only be a valuable vehicle to help you provide for the costs of a college education, but also to protect your children from receiving a large sum of money that they aren't spiritually and socially equipped to handle yet.
With so many benefits, you would rightly suspect that 529 plans must have some flaws. Indeed, there are at least two to be considered. First is that 529 savers are limited to a relatively small range of investment options selected by the state -- a significant downside for those who want to manage their own portfolios. The second major downside of 529 plans is an ominous cloud lurking on the horizon named "sunset." If Congress doesn't specifically extend the tax-free nature of 529 plan earnings beyond 2010, distributions will revert to being taxable to the student when received. This could mean that the tax-free earnings savers thought they were signing up for don't turn out to be tax-free at all. While this doesn't seem likely, it would be naive to not consider the possibility that it could occur. However, even under this worst-case scenario, the years of tax-deferred savings combined with a typically low student tax rate would still make saving in a 529 plan a very solid choice.
Choosing the Right Section 529 Plan
With over fifty 529 plans to choose from, it's crucial to know what factors are important when comparing plans. One key component is the rate of return you can expect. Unfortunately, many plans have short track records, and there's no easy way to compare returns of multiple plans at a glance. However, understanding how 529 plans invest can give you some idea of what to expect from each type of plan.
Section 529 plans invest your money in a diversified portfolio of stocks and fixed income securities. While many plans allow you to pick an investment track -- conservative, moderate, and aggressive for example -- beyond that, until recently there used to be no way to change the investment allocation of your account. You see, it's the nature of these plans that, even though it's your money going into the plan, you forfeit the right to make investment decisions. That's the tradeoff that gives these plans their tax-advantages. Most 529 plans offer age-based mutual fund portfolios that invest your account mostly in stock funds when the child is young, and increasingly shift to bond and money market funds as the child gets closer to college age. In that respect, they're an easy auto-pilot way to save for many investors. But there's a huge variation in how aggressive various states are in their allocations. For example, New York recently made their age-based portfolios more heavily stock-weighted, but even in the aggressive track, an 11-year old is still only 50% in stocks.
Thankfully, many plans are adding features that allow some fine-tuning. In addition to age-based portfolios, static portfolio options are being added. It's not unusual anymore to find states offering multiple static choices, like the following options Nebraska now offers in addition to their four age-based options:
