College savings plans
January 10, 2011
Saving money for a child's college tuition is an important goal for parents. Unfortunately, college expenses seem to increase at a faster rate than parents can manage to save money. College tuition increases have risen faster than general inflation, and to make matters worse, parents may see the value of their college savings fall if the stock market hits a rocky road.
If you are a parent who is finding the task of saving for college almost overwhelming, don't give up. A systematic savings plan and smart investment choices can make the dream of paying for college a reality. The first step is to understand your different options and the varying ways you can sock away money for college. MoneyRates.com has listed some of the options that parents have for their college savings and where to look for the best college savings deals.
One way to reduce college expenses is to qualify for an academic scholarship. Even with the U.S. economy growing slowly, there are foundations, companies and organizations that are giving away college money. It is a good idea to apply for scholarships and grants if your child has excellent grades or exceptional talent in an area, but parents should not rely solely on the hopes that their child will qualify for a scholarship to pay for college. The earlier that parents can start saving for college, the easier paying future education expenses will be when that day comes.
529 college savings plans
A 529 plan, named after Section 529 of the Internal Revenue Code, is a savings plan designed to encourage investing money for future college costs. The main feature of a 529 plan is the wide variety of investment options and tax advantages that vary from state to state. 529 plans, also known as qualified tuition plans, are sponsored by either states, state agencies or educational institutions.
Currently, there are two types of 529 plans: (1) pre-paid tuition plans and (2) college savings plans managed by fund managers. Investors can place their funds in any 529 program, but can lose potential state tax advantages if they do not use the designated fund manager for the state in which they reside. Picking the best 529 savings plan can be tricky.
Parents have to evaluate the fund options in a 529 plan, as well as the historical returns, portfolio holdings and expense fees of each fund. In addition, it is important to choose a 529 plan with age-based options. For instance, a child only two or three years away from college should have a different allocation of assets than a child with another ten or twelve years to go before they enter college.
Parents should also remember that 529 plans can be used to save for more than just four-year colleges and universities. 529 distributions can go to tuition and expenses for community colleges, graduate-level schools and technical schools as long as they are accredited. 529 laws also allow two withdrawals a year that can be used to pay for computers, books and other expenses other than tuition.
The poor performance of many 529 plans in the past put a spotlight on the high administrative fees that some plans have been charging. Lawmakers in several states have taken measures to protect parents from excessive fees in their state 529 plans.
There are several excellent resources for parents who want more information on college 529 savings plans. A complete list of 529 plans listed by state with fees, limits, and options is listed on Sallie Mae's College Answer website.
The Financial Industry Regulatory Authority (FINRA) website also has information on investing with 529 plans. Because many brokers receive a commission for steering parents to a particular 520 plan, independent research on sites like these is always recommended. MoneyRates.com also has a question-and-answer article on Section 529 College Savings Plans that also contains useful information for parents.
Custodial accounts (either UGMA or UTMA) set up at a bank, mutual fund or brokerage firm give a designated custodian full discretion over investment decisions for the benefit of a minor. Custodial accounts have no restrictions on deposits and no penalties for early withdrawal. The disadvantages of a custodial account is that they are taxed annually as well as at withdrawal. In addition, at age 21 the child has complete control over the account and funds.
Funds in a bank custodial account can be held in certificates of deposit, money market accounts or savings accounts. If a custodial account is set up at a brokerage firm or mutual fund, the owner can buy stocks, bonds or mutual funds. Custodial accounts are best used by parents/custodians who are confident that their portfolio management can outweigh the tax consequences of custodial accounts. If you are interested in setting up a custodial account for your child contact your bank, mutual fund or brokerage firm for more information.
Retirement savings accounts
The Education IRA has been renamed the Coverdell Education Savings Account. The Coverdell ESA was created to give individuals a way to save for a child's elementary/secondary school education, as well as for college, graduate school, or vocational school in the same investment vehicle.
The account must be established for the benefit of a child under the age of 18 with all contributions made before the beneficiary's 18th birthday. As of this writing, an individual can contribute up to $2,000 annually to a child's Coverdell ESA if their modified adjusted gross income is less than $95,000 as a single tax filer, or $190,000 to $220,000 as a married couple filing jointly in the tax year in which they contribute. All earnings in the account will accumulate tax-deferred and can be withdrawn tax-free if used to pay for any qualified education expenses portfolio.
A Roth IRA can also be used to save for college. When parents saves for college using a Roth IRA, the money can be withdrawn with no taxes or withdrawal penalty. If the child does not go to college, the funds stay in the Roth IRA.
Using a Roth IRA for college can be tricky because your money is commingled with retirement funds. Parents will need to keep close tabs on their asset allocation as the time to pay for college approaches.
Prepaid college savings plans
Prepaid college savings plan offer parents the chance to pay for the future cost of college at today's prices. This form of prepayment of college tuition can lead to large discounts on future costs, especially if inflation outpaces the rate of returns on your college savings accounts. Prepaid plans are available from 18 different states that can give parents federal and state tax benefits. Plan details vary from state to state.
The Private College 529 Plan, is one prepaid plan that has over 200 major universities participating in the program including top-ranked schools Stanford, Princeton, Duke University and Washington University in St. Louis. The plan is sponsored by Tuition Plan Consortium LLC and a subsidiary of TIAA-CREF is the program manager.
Paying for college early can offer some advantages. If you assume that private college tuition inflation continues at an average rate of 5 percent per year and factor in the Private College 529 Plan annual discount rate of 1 percent, then paying tuition early is the equivalent of earning a 6 percent rate on your college savings funds each year tax-free. Investing college savings in the stock market may beat 6 percent, then again the market is volatile and your timing may be bad. The participating universities are contractually obligated to honor the tuition payments (called certificates) issued today, even if the university withdraws from the program in the future. If a child is not accepted or does not wish to attend a school on the list of participants, then there are three redemption options:
- You can get a refund and retain all the tax benefits for the withdrawal portion, if the funds are used for qualified higher education expenses.
- You can change the beneficiary.
- You can roll over funds into a state-sponsored 529 plan.
Student loans and social networking
A student loan is financial aid given to a student by a federal or private lender that is specifically intended for education costs. These loans usually carry lower interest rates than other loans and are frequently issued by government agencies. Comparison sites allow parents and students to search for private and federal loans. Rates, terms and the total cost of a student loan can all be compared and contrasted to help find the most appropriate loan for the potential student. The debt on a student loan is assumed by the student upon graduation, unless a co-signer exists who would share the responsibility.
Social networking is another innovative way to save for college. Popular sites have launched that help students obtain loans for college by setting up a social network with friends, families, and others. Members of the network can choose to lend money to the student through a secure online platform with flexible lending terms.
Other social networking sites help making saving for college a reality by creating online savings goals that can be publicized in order to raise funds. College savers can hold funds in a FDIC-insured bank account, while earning a high savings rate until they meet their savings goal. Saving for college by using social networking tools can help create a sense of responsibility for a student. The student knows that they are being funded from personal contacts, not an impersonal government entity.
College reward credit cards
Parents can save money for college as they spend with college reward credit cards. These cards will pay cash back from credit card purchases that is deposited directly into a college savings plan. The more you spend, the more you save for college.
Before signing up for a college rewards card, check the offering carefully to make sure that your state's 529 plan is included as one of the participating states. Also you should remember that the interest rate on your card can be higher than normal credit cards. If you plan to carry a balance on the card, you may be better off with a low-interest card and making your own 529 college savings contributions.
Bank accounts and U.S. savings bonds
A bank deposit account can be set up for a minor at a bank either jointly with a parent or in a custodial account. If you use certificates of deposit to save for college, you can ladder your CD maturities so that they mature when you expect your college tuition payment will be due.
MoneyRates lists the best CD rates to make the job easier. The downside for parents who use bank CDs and other savings accounts for college savings is that tuition inflation can outpace the interest rate on their bank savings account. If this happens, meeting college savings goals can become more difficult.
One of the most traditional forms of college savings is U.S. Savings Bonds. Grandparents, aunts, uncles or family friends can all buy federally-backed savings bonds directly from the Treasury Department in denominations as low as $50. When you buy a savings bonds online, you are subject to a maximum of $5,000 in gifts per year for both Series EE Bonds and Series I Bonds.
Savings bonds remain a favorite of senior citizens who appreciate the safety and security that purchasing a savings bond can offer. College savers who would like more information on U.S. Savings Bonds can visit the Treasury Department's website.
Child development accounts
Child Development Accounts (CDAs) are savings or investment accounts that can help parents start saving for college as early as when a child is born. The goal is to redistribute funds to improve the ability for all children to attend college, not just wealthy children. CDA programs were first started in Canada, the United Kingdom and Singapore.
Ideally, matching funds from the private and public sector supplement the CDA savings for each child. If that program is not politically feasible, another option is for governments to deposit a lump sum into a college savings programs at birth.