7 Easy Ways to Save for College
When it comes to saving for college, thinking about the future cost can be paralyzing. But don't get intimidated by the numbers. Get moving, and set your sites on saving at least one-third the cost. Plan to pay one-third out of your current income and financial aid when your child enrolls; and the other third through loans and grants.
The easiest way to save is a 529 college savings plan. Why are they the best choice? You can open one of these state-sponsored accounts with as little as $5. And your savings grow faster because the money grows free of federal and state taxes, and withdrawals are federally tax-free if used to pay for qualified education expenses, such as tuition, fees, room and board, and books.
Meanwhile, the 529 account owner -- parent, grandparent, or other investor -- retains control of the account (unlike custodial bank accounts, in which the child can access the money when she reaches legal age, and blow it all on a Porsche).
To get you started, here are the answers to five of the most common questions parents ask about college savings plans.
Which 529 Plan Is Right for My Family?
There are two kinds of 529 plans -- savings and pre-paid programs. In the former, your account can be used to pay college costs anywhere in the U.S., and at some foreign institutions. Each investor can contribute up to $12,000 per child a year, to a typical maximum of $220,000. Pre-paid plans are exactly as they sound -- you pre-pay future tuition in today's dollars at a specific institution. Most families choose a Savings plan, which provides the most flexibility and control over where the money is used.
Sixty-five state plans allow you to open an account with $50 or less. And roughly a dozen states match the contributions of low-income families. The states sponsor a site, collegesavings.org, that offers the ability to compare plans, and link to each state's website.
Check out your own state's plan first, because it may offer a tax incentive to residents. For instance, New York taxpayers can also deduct up to $5,000 of contributions ($10,000 for a married couple filing jointly) on their state income tax return each year.
If your state doesn't offer a carrot upfront, look for the plan with the best investment performance and the lowest fees. Several sites review 529 plans and pick the best, including Kiplinger.com, the personal finance site; Morningstar.com, the mutual fund site (registration required); and savingforcollege.com (monthly subscription, $14.95).
How Do We Open an Account and Choose Investments?
Ideally, open your account directly with the state's website -- because financial professionals typically charge a fee to do it for you. Most importantly, set up an automatic monthly transfer from your checking account into your 529 plan to keep it growing.
Each 529 plan offers a range of investment options, usually mutual funds. Confused by the choices? Consider going with an "age-based" investment option. Your savings are invested in more aggressive instruments, like stocks, when your child is young, and shift to more conservative vehicles, like bonds, as your child gets closer to college.
If you are ultra-conservative and don't want anything to do with stock or bonds, some states offer 529 CDs or bank accounts, which are FDIC-insured.
How Much Should We Save?
Let's say you have a 1-year-old who you plan to send to your state university. You have 17 years to save. You could simply set aside what you can afford -- automatically transferring $25 a week from your checking into your 529 plan. If your money grows at 7 percent, you'll have more than $39,000 saved for college by the time your 1-year-old is ready to enroll. Another method is to crunch the numbers on a college savings calculator. Let's say you want to save one-third (33%) of the cost for your 1-year-old. The average cost of tuition, room and board at a public, four-year school was about $13,600 last year, according to the College Board. I used this number in the savings calculator, and it told me I need to start putting away about $215 a month -- or $7 a day -- to meet my goal.
Note that the calculator assumes a conservative interest rate on your savings of 4 percent a year; if you're able to achieve 7 percent, you only need to save $5 a day to meet your goal.
Recognize it's far cheaper to save for college than to borrow. If you start saving when your child is eight and save $200 a month for 10 years at a 6.8 percent rate of return, you'll accumulate about $34,400. If you borrow that amount in federal loans and pay them back at 6.8 percent interest instead, you'll pay back $396 a month for 10 years. Bottom line: Save upfront or pay twice on the back end.
Will Investing in These Plans Make it Harder to Get Financial Aid?
Don't shy away from 529s thinking they will hurt your child's ability to receive financial aid. "Aid in the form of grants has been cut back pretty dramatically, and most people who receive financial assistance are likely going to have some combination of grants, loans and work-study," says Jackie Williams, executive director of Ohio Tuition Trust Authority, which runs Ohio's 529 plan. "Those who think they will qualify for full aid, or think they are going to get a scholarship, have a mistaken perception about what's available."
According to Mark Kantrowitz, founder of finaid.org, 529 savings barely affect aid eligibility. Financial aid formulas ignore money saved in retirement funds, net home equity, and small business owned or controlled by the family, he says. Of the remaining assets, the first $45,000 to $50,000 is sheltered, depending on the age of the older parent, he explains.
"The remaining assets are assessed on a bracketed scale, with the top bracket at 5.64 percent. So if you save $10,000, the worst case impact is a $564 reduction in aid, leaving you with $9,436 more than you would have had otherwise."
Another painless way to save is signing up with a loyalty-rebate program such as Upromise or Babymints, that deposits the rebate directly into your child's 529 plan. (See finaid.org for a list of loyalty rebate programs.)
What Happens to Our Money if Our College Plans Change?
What if your child doesn't go to college, receives a scholarship or doesn't attend the school where you pre-paid tuition? You can transfer the money in a 529 plan to another family member -- nephew, niece, eventual grandchild or even use the money yourself to go back to school.
There are also ways to transfer pre-paid tuition to other institutions. If your child gets a full scholarship, you can withdraw the money you put in without penalty, but your interest earnings will be taxed at your child's tax rate.
Now if you decide to pull the money out and blow it on a trip around the world, your investment earnings will be subject to a 10 percent penalty and taxed as ordinary income at the parental tax rate. So stay focused on college. Seeing your successful graduate launch her career without a mass of student loans will be more rewarding than a trip abroad.