After you’ve spent a small fortune on diapers, baby food, strollers, toys and more, you start to think that maybe it’s time to start socking money away for your little one’s college education.
Not so fast, says H. Jude Boudreaux, senior financial planner at The Planning Center, a fee-based financial planning firm in New Orleans. “First, make sure you are on track for taking care of yourself before you begin investing for your kids,” he says. “To use the airline analogy: Put your mask on first before you put your kid’s mask on.”
Got your financial mask on? OK, let’s talk about investing now for future college expenses. Congress has established a variety of tax-favored plans to help you save for your child’s college education. Depending on your circumstances, some may work better for you than others.
Section 529 plans
If you talk to a financial adviser, you’ll discover that Section 529 plans are the vehicle of choice to save for college. These plans, which are sponsored by virtually every state and also by many colleges and universities, come in two basic flavors:
Prepaid 529 plans. If you’re intent on sending your children to in-state schools, you can set up a prepaid plan for each child that essentially allows you to pay that school’s tuition now at today’s rates years in advance. That way, if tuition skyrockets, you’re locked in at lower rates.
That sounds good, of course, but it’s not right for everyone. “I don’t recommend these plans for people with young children,” says Dave Grant, CFP and founder of Finance for Teachers in Cary, Illinois. “You’re taking a huge risk that the money won’t be there 10 or 15 years down the road when you need it.”
You also run the risk that your child may want to go to a school outside your state. “In that case, you have limited transfer options,” Grant says.
Savings 529 plans. These plans allow you to invest in a variety of mutual fund-like options within a particular plan. Typically, your investment choices are limited to different stock and fixed-income accounts. Some 529 savings plans may limit your investment choices to portfolios geared to specific risk tolerances or to the ages of your children.
For example, the State of Illinois’ “Bright Start” plan offers six age-based portfolios and five choice-based portfolios, each reflecting a given time horizon and risk tolerance, with investment options from the Vanguard and T. Rowe Price, among others. Finally, that plan lets you select an actively managed or index strategy.
“Most states have their own plan, and some states have multiple plans,” Grant says. “And you’re not limited to your own state’s plan, so there are a lot of choices out there.” You also can invest in most of these plans through your broker, although if you do, you may have to pay a commission.
Depending on the state, you can contribute as much as $500,000 to any one child or beneficiary. Even though you can’t deduct your contributions on your federal income taxes, some states provide tax incentives. Your invested money grows tax deferred, and as long as you use the money to pay qualified education expenses, you pay no taxes on withdrawals.
Finally, money you contribute to the plan is no longer part of your estate, although the funds are controlled by you, not your child. Therefore, if the intended beneficiary chooses to not attend college, you can name another beneficiary. “You can even redirect it toward yourself if you want to return to college later in life,” Boudreaux says.
However, 529 plans do have a few drawbacks. For example, if you don’t use the funds to pay qualified educational expenses, you must pay both an income tax and a 10% penalty on any earnings when you withdraw the funds.
“This is on money that probably has been tax-sheltered for many years,” Boudreaux says, “so we have a lot of upside with these plans and very little downside.”
Find out more about 529 plans, including a ranking of the top performing plans, at savingforcollege.com.
Other tax-favored options for investing
Coverdell Education Savings Account (formerly Education IRA). Given new life by the American Taxpayer Relief Act of 2012, these accounts have two advantages over a 529 plan: You can use the money to pay for K-12 education expenses as well, and your investment options are more flexible, similar to a self-directed IRA.
It’s all downhill from there, however. Contributions from any source are limited to $2,000 per year per child. Parents get to make the investment decisions, but distributions go directly to the child. Any money remaining in the account when your child hits 30 must be distributed or transferred to another eligible family member, unless the beneficiary is a special needs beneficiary.
“If it’s not used for education expenses, then income taxes and the 10% penalty are due,” Grant says. “But you can roll the balance into another Coverdell account for another child.”
Series EE/Series I Bonds. If you’re really risk averse, consider government-backed EE/E and I series saving bonds. You can buy them online in increments as small as $25. If you use them later to pay qualified education expenses, the interest earned is tax free. If you don’t, it’s not.
The drawback to these kinds of bonds, according to Bryan Sudweeks, associate professor of finance at Brigham Young University, is that “for most parents, these expenses are defined very narrowly and include only tuition and required fees.”
No strings attached, but no tax favors either
A conservative investment portfolio. For total flexibility and virtually no IRS strings attached, consider setting up a conservative investment portfolio designed with your child’s education in mind. No tax deferral, no tax-free withdrawals and no worry about qualified education expenses—just good old-fashioned investments.
“The portfolio should be well-diversified, with something like a 50/50 or 60/40 mix of stocks and bonds,” Boudreaux recommends. As your child’s college matriculation nears, move the money into something more conservative, even cash. “Stability and certainty are more important than possible extra yield at that point,” he says.
Student loans. Rather than save now, you can pay for your children’s education later by simply agreeing to re-pay their student loans—if they graduate, and up to a pre-set limit.
“Don’t co-sign for the loans and set some parameters,” Boudreaux warns. “That way, they have some ownership.”
