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Parents’ guide to saving for college

Your choices, and why you should start putting away money early

Published: February 2013

More than $350,000 to pay for college!?! Well, if you had a baby this year, that’s what it might cost for him to spend four years at a private college beginning around 2030. That staggering estimate is based on average total charges (tuition, fees, and room and board) at private colleges in the U.S. climbing 4.4 percent, as the College Board reports for the 2011-2012 academic year.

Of course, few people can or do pay these huge amounts—at least not right away. According to the College Board, in the 2010-2011 school year, the most recent statistics available, a whopping $227 billion of the nation’s collective college bill was covered by grants, work-study programs, federal loans, tax credits, and deductions; and about $79 billion came from state and private loans. For the 2011-2012 school year, the average family sending a child to a four-year public college spent an estimated $11,380 out of pocket just for a year’s worth of tuition, fees, and room and board, while those out-of-pocket expenses for a child attending a private four-year institution were $23,060—about 60 percent of the total bill. So you’re still going to have to fork over plenty of your hard-earned dollars.

Bottom line: Start saving now. As with any investment, the earlier you start, the more your money can grow. “Aim for $250 or more per month if you can manage it,” says Mark Kantrowitz, publisher of Fastweb.com and Finaid.org. “Make it automatic and start now.”

Here are a few more things to consider when planning your college-savings strategy.

Keep yourself out of the poor house
Don’t save for your child’s education at the expense of your retirement, savings, insurance, and everything else in your budget. And while you don’t want your kids to be drowning in debt when they graduate, it’s not inappropriate for them to share some of the burden. Your kids might wish you’d just pick up the tab, but it would probably cost them much more in the long run if you show up broke at their doorstep during your "golden" years. So a healthy budgeting balance is key.

Minimize costs beforehand
It’s estimated that two-thirds of college graduates have an average student-loan debt of more than $25,000 at graduation. Unlike most consumer loans, student debt generally can’t be discharged by declaring bankruptcy. Lenders can recover the funds by garnisheeing tax refunds, up to 15 percent of wages, and even up to 15 percent of Social Security benefits. However, if you are unemployed, your payment of the loan’s principal balance can be deferred. In fact, depending on the type of loan you have, the government may even pay the interest during the deferment).

Here are some ways to keep your child’s college costs low enough to bypass some of the borrowing and spending in the first place, without suspending the flow of his or her academic career.

  • Have your child opt for community college for two years and then transfer to a four-year institution, or attend an in-state public university.
  • Fill out the Free Application for Federal Student Aid (FAFSA), as soon as possible after Jan. 1 for each coming academic year to determine your eligibility for need-based assistance, which doesn't need to be repaid.
  • Take advantage of all grant, scholarship, and work-study opportunities.
  • Choose thriftier meal plans and housing if you can.
  • If you do take out a loan, don’t use it toward such nonessentials as entertainment and room furnishings. Have your child consider working part-time to cover incidentals.

Federal loans are safer than private

If your child uses student loans, keep in mind that private loans outside the federal student loan program often come with high variable interest rates, additional loan fees, and strict repayment requirements, even if borrowers are unemployed or can’t afford the payments.

If you must borrow, avoid using private loans except as a last resort, even though their interest rates may initially be lower than federal loans. That's because federal loans starting in 2011 have a fixed rate of 3.4 percent, and Congress passed last-minute legislation this year that extended this rate for an additional year. Unless Congress takes further action, the interest rate on new loans on/after July 1, 2013, will be at 6.8%, notes Kantrowitz. Most private loans have variable rates often tied to the London Interbank Offered Rate (LIBOR). Home-equity loans, which can be cheaper, are also riskier because they can cost you your home if you default.

Put it in the parent’s name.
Financial-aid formulas usually treat parents’ assets more kindly than money belonging to a child. That is, they expect the student to contribute a far greater percentage of his assets to pay the bill. If you expect financial aid to be a major factor in paying for college, try to have more money in your name and less in your child’s.


Ways to save for college

The chart below provides an at-a-glance comparison of the main college-saving options.

Method Income limits Contribution limits How funds can be used Type of investments Tax benefits
529 plan None. State cumulative contribution limits range from $146,000 to $305,000. Contributions that exceed $13,000 per year may be subject to gift taxes.
For qualified higher educational expenses as defined by the government. Individual mutual funds, age-based portfolios. No taxes on income or withdrawals used for qualified expenses. Contributions to in-state plans may be deductible on state tax return.
Roth IRA For 2012, under $110,000 for single filers; $173,000 for couples. $5,000 per year, $6,000 if over age 50. After 5 years, no penalty for qualified expenses for self, spouse, children, or grandchildren. Virtually unlimited. After 5 years, no federal or state taxes on earnings if owner is 59½ or older.
Coverdell ESA For 2012, under $110,000 for single filers; $220,000 for couples. In 2012, $2,000 per year, per child. For qualified expenses at elementary school, secondary school, or college. Stocks, bonds, mutual funds, bank deposits, CDs. No taxes on income or distributions for qualified expenses.
Prepaid plan None. Typically ranges from $50,000 to $100,000. For tuition at in-state or in-network college. No investment options. The price of the contract is determined prior to purchase, and the programs then pool the money and make long-range investments so that the earnings meet or exceed college tuition increases. Earnings are not subject to federal tax and generally not subject to state tax.

529 college-savings plans

Named for a section of the federal tax code, these plans are actually administered by states, and now attract the most savings for higher education.

You can invest after-tax dollars, up to the limit set by that state’s plan, and as long as the money is used for qualified college costs you won’t pay any more federal taxes on your investment or earnings. Qualified costs typically include tuition and mandatory fees; books, computers, and other required supplies; and room and board if the student attends at least half-time. Qualifying schools include any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education, and offering credit toward an associate’s, bachelor’s, graduate-level or professional degree, or another recognized post-secondary credential.

What if your child decides not to use the money toward a college education? A 529 allows you to change the beneficiary to another family member. If you decide to simply withdraw the money, you will have to pay a 10 percent penalty as well as state and federal taxes on the account’s earnings—though not on contribution amounts.

You don’t have to invest in your own state’s plan, although that’s where you should look first, because many states provide tax deductions for in-state investors. (Go to www.finaid.org to see whether your state is among them.) The plans generally offer a few investment options, but it varies from state to state. One of the best websites on 529 plans is www.savingforcollege.com, which is owned by Bankrate.com and offers news and information on all state programs. You can also find general information and links to your state's program, as well as comparing your state’s plan with competing ones, at www.collegesavings.org.

When assessing different 529 plans, compare these features.

Extra fees and expenses. State 529 plans vary widely in their investment options and their investments are subject to expenses and fees (such as application and maintenance fees) that can vary dramatically and take a good bite out of your college savings. Fees for 529 plans can go up as high as 1.5 percent each year of the money you’ve invested. Ideally, “You want the plan that has fees under 1%,” says Mark Kantrowitz. 

The most economical way to sign up is to invest directly and avoid the commissions, which you might incur by going through a financial adviser. There’s also the risk that an adviser may steer you to an inappropriate out-of-state plan simply because he or she stands to earn a higher commission. When comparing state agencies and investment advisers, “the fees will be much higher with investment advisers, who are influenced by commissions,” says Kantrowitz. Check state plan websites directly, he suggests, where you can set up a plan, as well as find phone numbers and forms to print out and mail in. You can find state 529 websites through www.collegesavings.org and www.savingforcollege.com.

Investment options. These plans vary widely. Some 529s offer a choice of individual mutual funds or age-based plans that are structured somewhat like target-date retirement funds—they invest more aggressively when the beneficiary (the student) is young and adjust the portfolio's asset allocation to more conservative investments as he or she gets close to college age. The major difference is that with a 529 plan, you're saving for about 18 or 20 years and spending all of it in four years or so.

The sooner you need to get your money out, the more conservatively you should usually invest it. With a new baby, you can probably afford to take some chances, but when your child reaches high-school age, you may want to shift at least gradually into one of the less-risky options. You can also diversify your 529 by spreading your money among several types of investments. Learn more here.

Most successful long-term investment plans should be based on the familiar structure of stocks, bonds, and cash; over a 15- or 20-year span, returns on more conservative bank certificates of deposit will almost certainly fall short. Learn more here.

The value of tax deductions
Skewing conservative can present an obvious problem: how to keep up with the annual inflation rate of college costs—anywhere from 3 to 9 percent, depending on the type of school. Expectations for stock returns have been lowered recently to about 7 percent a year in average long-term performance. Fortunately, some plans have sliced expenses, which will help overall performance.

Favorable tax treatment provides a boost. For example, New York allows individuals to deduct contributions to in-state 529 plans of up to $5,000 ($10,000 for married couples filing jointly) on state income-tax returns. In Illinois, individuals can deduct $10,000 a year ($20,000 for joint filers). Then again, some states don't have state income taxes to begin with.

Depending on where you live and the plan you choose, that tax benefit might make up for some drags in plan performance. To test this theory, we analyzed how a 529 investment might do for a couple earning $100,000 in five higher-taxed states' plans vs. an out-of-state plan that doesn't allow you to deduct contributions on your state income tax. An out-of-state plan that earned one percentage point more than an in-state plan would be more advantageous in four of the five states we analyzed.

Other ways to save on your taxes while saving for college can be found at the IRS’s Tax Benefits for Education and the American Opportunity Tax Credit pages.

Quick tips to make the most of 529s



Get a jump on saving.
You don't have to wait for the stork to arrive to open a 529 account. If you want to set one up before you have children or grandchildren, you can designate yourself as the beneficiary and transfer the assets to the child later.

Invest on a regular basis. Use dollar cost averaging to build your college savings by putting aside a set amount at regular intervals. Many employers offer automatic payroll deductions for 529 plans. If yours doesn't, consider making an automated transfer from a checking or savings account.

Make it a family affair. Some 529 plans provide gift-certificate forms or contribution slips to help family members and friends make direct contributions to a child's plan for birthday or holiday gifts.


Roth IRAs, U.S. savings bonds, and more

Roth IRAs
Roth IRAs can be a smart way to save for higher education. They’re retirement accounts financed with after-tax dollars that provide tax-free income once the owner reaches 59½ and has held the account for at least five years. But even if you're younger, you can withdraw your contributions (but not earnings) without a tax penalty after five years.

You're eligible to fund a Roth IRA if your 2011 adjusted gross income is less than $110,000 for singles ($173,000 for couples).

The main advantage to using it for college saving is flexibility—you choose how to invest the money instead of being locked into a 529 plan's investment options. And perhaps more important, if your child or grandchild decides not to go to college, you can continue to fund the account for your retirement. By contrast, if you don't use the money in a 529 plan for qualified educational expenses, you'll pay a 10 percent penalty on any gains the plan has earned over the years.

Custodial accounts
You can also sock money into a custodial account. Often called UGMAs (for Uniform Gifts to Minors Act) or UTMAs (for Uniform Transfers to Minors Act), they allow you to invest as much as you want per year in your child’s name, free of any gift taxes.

But there are drawbacks. A custodial account could have a severe negative effect on your child’s eligibility for financial aid. Most financial aid formulas treat assets belonging to a child (as UGMAs and UTMAs are considered to be) less favorably than those of a parent (as is the case, for example, with 529 plans). “There’s not as much benefit to these accounts, and a hit to aid eligibility,” says Kantrowitz, making them a less than ideal savings vehicle.

A potentially bigger problem is who controls the money. The trustee (presumably you) has control until your child reaches age 18 or 25, depending on the state. After that, it’s the kid’s cash to do with as he pleases. If you have substantial assets to invest on your child’s behalf and want to retain greater control over the money, a lawyer can acquaint you with other types of trusts.

U.S. savings bonds
U.S. savings bonds may be eligible for special tax treatment if you cash them in to pay for higher education. You don’t have to indicate your intention to use the bonds for college when you buy them, so you can always change your mind. But they need to be registered in your name and/or your spouse’s rather than your child’s. Interest earned is tax-free as long as your modified adjusted gross income is under certain limits. They are popular with grandparents, but instead of investing in U.S. bonds, generous family and friends should be encouraged to contribute to a 529 in the child’s name, suggests Kantrowitz. For more details, visit www.publicdebt.treas.gov. And learn more about how to buy a savings bond.

Regular investing
You can also simply invest on your own to cover your child’s college costs. You’ll miss out on some of the tax breaks mentioned above, but you’ll also have more flexibility in what you ultimately do with that money.

Coverdell education-savings accounts (530)

Like 529s, education-savings accounts, or ESAs, allow you to save money for qualified educational expenses, covering anything from kindergarten through a PhD. With these “education IRAs," as long as your adjusted gross income is less than $110,000 for individuals and $220,000 for couples, you can invest for a child under age 18, and they can use it until they’re 30. While you don’t get any tax break for your contributions, the money in your account grows without being taxed on its earnings, as is the case with a regular IRA. But unlike a regular IRA, money you withdraw to pay qualified educational expenses is free from federal and sometimes state tax.

One serious drawback: ESAs only allow you to deposit $2,000 per year. But you can contribute to a 529 and a Coverdell simultaneously. And Coverdells allow you to decide how to invest the money. If your child doesn’t go to college, you can change the beneficiary to another child or yourself; but like the other savings plans, withdrawal for anything but qualified expenses will incur a 10% penalty on the earnings, as well as subject them to taxes at the beneficiary’s rate. You can open a Coverdell account at many mutual fund companies as well as banks and brokerage firms. But note that some provisions of the Coverdell are due to expire at the end of 2012. The current $2,000 contribution will decrease to $500, and expenses for K-12 will no longer be allowed.

Prepaid-tuition 529 plans

Some state 529 programs offer prepaid plans, which let you buy credits to cover tuition at a particular college or group of colleges and allow your funds to grow at the same rate as in-state public university tuition. Though less flexible than regular 529s, they allow you to lock in tomorrow’s tuition at today’s prices. But due to foundering state budgets, some states have put the brakes on prepaid tuition plans, either by no longer offering them to new participants or by paying out somewhat less than a fully prepaid tuition. “These plans don’t perform well in a down economy,” says Kantrowitz. “There’s an illusion that it’s risk-free, but there’s always going to be a shortfall.” Because 529 college-savings plans operate like retirement funds—more risk earlier on and less risk as you approach college age (also known as “age-based asset allocation”)—the reality is that you can control risk better with a 529 college-savings plan than with a prepaid tuition plan. “All families should be in them,” Kantrowitz says.

Private college 529 plans
Also known as independent college plans, this is one way to sidestep state fiscal woes. Historically, private colleges cost roughly twice as much as state universities. This plan allows you to purchase tuition certificates good for credits at a participating school for up to 30 years—if you’re sure of where your baby will spend her college years. Learn more at www.privatecollege529.com.

If your child decides to go to a different school or not go at all, you have options with either. You can change the beneficiary child at any time, or change it to yourself or another qualifying family member; roll the account into a state-sponsored 529 plan; or leave the account open for up to 30 years from the time you enroll. As with any 529 program, you can get a refund, but any earnings will be subject to federal income tax as well as an additional 10% tax. You can also roll a 529 college-savings plan into either a prepaid or private college 529 plan or vice versa.

   

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