Start saving as soon as possible. The miracle of compounding makes getting started now the most important part of any large expense that's still several years away. Most of this money should be in stocks, since bonds and other investments historically have had trouble keeping up with the rising costs of a college education. As your child gets closer to his/her college years, begin to move the money from stocks to safer investments such as bonds and money market accounts.
While it may seem counterintuitive at first, saving for your retirement can actually help your children pay for college. Many financial aid programs and colleges don't count your retirement savings when calculating how much you're able to contribute to your children's college costs. If you think your family has a good chance of being eligible for financial aid, it's best to keep all savings in your own name. While your children's income would probably be taxed at a lower rate than yours, keeping funds in your children's names can make getting financial aid much more difficult.
Having said that, there are several investment options to consider when deciding where to put your money. State-sponsored section 529 plans, prepaid tuition plans, and IRA plans can be used to finance your child's college education while keeping the money in your name. Should you decide to keep the money in your child's name, the UGMA account is an option to consider. The following sections will go over each of these options in more detail.
Section 529 Plans
Section 529 Plans are state-sponsored programs, available in over forty states, designed to help finance your child's education. The states appoint investment companies to administer the accounts, while setting contribution limits and investment guidelines. There are several benefits to this investment option that make it attractive to investors. First, anybody can contribute to a Section 529 Plan, regardless of their income level. Several states allow the investor to contribute up to $200,000 per beneficiary. Second, withdrawals from the account are federal tax-free if used for approved educational purposes. Third, when the Section 529 Plan is being set up, the investor selects the plan and determines the contribution amount.
A drawback of this plan is that the proceeds can only be used for education; withdrawals for non-educational purposes trigger taxes and a 10% penalty. Also, the investment company administering your account will be in control of how your money is invested. In most cases, the money is invested in a portfolio of stocks, bonds, or mutual funds. So it is a good idea to shop around before you select a Section 529 Plan. Since a rate of return is not guaranteed, evaluate the company's investment strategy and their historical performance, and ask about any fees associated with the plan.
State Prepaid Education Plans
Some states offer prepaid tuition plans, which allow you to pay the current cost of tuition for your child, with the guarantee that your child's tuition will be waived if your child attends a public school in that state. The problem with this is that if your child doesn't go to college, or goes to college in another state or in a private university, a portion of the money you've invested is forfeited.
Like the Section 529 Plan, there are no income restrictions, so this is a good investment to make if you know your child is going to attend a public university in a certain state and you feel it's unlikely that you'd be eligible for financial aid. The gains on the account are deferred until the withdrawal and are taxed at the child's rate. The investor does not have any control of what the plan invests in. Most prepaid education plans invest in state treasury bonds to keep up with rising in-state education costs.
Depending on your family's particular circumstances, each IRA has benefits and drawbacks. The Education IRA is ideal for paying for college, although the low contribution limit and the mutual exclusivity with the Section 529 Plans could deter you from investing in it. With a traditional IRA, proceeds can be used on education or retirement, although withdrawals are taxed. And with a Roth IRA, withdrawals are not taxed, but the contributions are taxed. We recommend reading the following descriptions of the various IRA's and deciding which IRA is right for you.
With the Education IRA, an investor can contribute up to $500 per year, depending on the investor's level of income. Similar to the Roth IRA, contributions are paid from after-tax income, while withdrawals are tax-free. If the account is not used for the child's college expenses, it may be transferred to another child for their educational expenses. A drawback of the education IRA is that you cannot make contributions to both a Section 529 Plan and an Education IRA in the same year. Although anyone who qualifies should invest in the Education IRA, the low contribution limit obviously won't let you save enough for your child's entire college expense, and should only be one part of your investment plan.
Contrary to the name, Individual Retirement Accounts, or IRAs, can also be used to help finance a child's education. The traditional IRA lets an investor contribute as much as $3,000 per year to the account, depending upon his or her income level. Some or all of the contributions may be tax-free, depending on the investor's income. Withdrawals are taxed at the investor's regular income tax rate. This account is in the parent's name, so if the money is not spent on the child's college expenses, the IRA can be used for the parent's retirement. The Taxpayer Relief Act of 1997 made it possible to withdraw funds from the IRA without incurring a penalty, as long as the proceeds go towards eligible college expenses.
Like a traditional IRA, a Roth IRA allows you to make withdrawals for a child's college expenses. Contribution limits are the same as for a traditional IRA, while the taxes incurred differ. Contributions are paid from after-tax income, but withdrawals are not taxed (subject to some restrictions). But if you don't use the withdrawal for eligible expenses, a penalty will be incurred.
The Uniform Gifts to Minors Act or Uniform Transfer to Minors Act (UGMA or UTMA) allows a parent to transfer ownership of investments or assets to a minor. Up to $11,000 may be transferred in a year, and withdrawals are taxed at the minor's rate. After the transfer, the assets become the legal property of the minor. The parent has no legal control over the usesof the proceeds of the account. UGMA accounts can be used for any expense, not just college, so a parent will have no legal say if the child decides not to spend the money on college.
Think carefully about putting money in a child's name. While a child's income will likely be taxed at a lower rate than the parent's income, putting money into a UGMA account may negatively impact the chances for financial aid. If your child will be eligible for financial aid, it would be beneficial not to set up a UGMA account, as financial aid officers weigh children's assets much more heavily than parents' assets.