It's hard to picture your baby all grown up and heading off to college. Then again, just a short while ago it was hard to imagine life with a baby. And when it comes to financial planning, now is actually the best time to think about saving for her higher education. Assuming tuition keeps rising the way it has, in 16 years a college diploma will cost $150,000 to $300,000.
"Those are some pretty depressing numbers," says Karen Schaeffer, a financial planner outside of Washington, D.C. and chairman of the Certified Financial Planner Board of Standards. The good news? "Your savings won't have to cover it all. There will be other options." Daunting as saving may seem, your best bet, Schaeffer says, is to give it the ol' college try: "Save as much as you can, and start now."
Time is on your side. You have many years to save and see your money grow in the stock market and to ride out its sometimes turbulent short-term ups and downs. With some smart investing, you can be ready for the tuition bills with a sizable chunk of cash in hand and a smart strategy for where to get the rest. Plus, some pretty generous tax incentives can help your savings grow tax free -- and you may even be able to deduct contributions to your tuition account. Here's a roundup of the pros and cons of the various college savings choices. Don't worry, there won't be a test later -- unless you count when your daughter asks to move into the sorority house.
529 Savings Account
Sign up for one of these state-sponsored plans, and your contributions go into a broad-based mutual fund that's reallocated annually based on your child's particular age. And you won't pay taxes on the earnings, thanks to a 2006 law change that made the tax break permanent.
PROS: High contribution limit (typically $250,000 per child); tax-free growth; pay no state tax on contributions in 32 states; beneficiary can be changed if the child doesn't wind up going to college.
CONS: Money must go toward education, or you'll pay a 10 percent penalty, plus taxes on the earnings.
BOTTOM LINE: New financial-aid rules have eliminated concerns that 529s could hurt a child's chances of receiving financial aid, subsidized loans, or work-study jobs because the money will now be counted among your assets, not the student's. And that puts 529 savings plans at the top of the class, says Joe Hurley, a certified public accountant who founded savingforcollege.com, a consumer information Web site widely considered to be the authority on the subject.
Prepaid Tuition Plan
Sign up for one of 15 state programs (review them at www.collegesavings.org) or the i529 -- a consortium of 260 private schools (www.independent529plan.org) -- and lock in today's tuition price with the money you contribute. Sound far-fetched? It's not. In fact, there are about 2.2 million prepaid tuition accounts compared with roughly 7.8 million 529 savings accounts.
PROS: Rather than investing your money in the market and hoping your return beats tuition inflation, you're guaranteed to come out ahead because you're getting the tuition price that's in effect when you make your contributions. You pay no taxes on the growth in the account, and contributions may be deductible from state taxes.
CONS: If your child doesn't attend a participating institution, you can withdraw the money penalty free for use at another school, but you'll get a maximum of only 2 percent growth for every year the money was in the account; money must be used for education expenses or you'll have to pay a 10 percent penalty, plus taxes on the earnings.
BOTTOM LINE: Choose a prepaid plan only if you're quite certain that Junior will be attending a participating school -- for instance, if the last four generations of your family have attended the University of Michigan, then it seems like a safe bet.
Education Savings Account (ESA)
Rather than enrolling in a state-run program, you can save the money tax free anywhere you want -- in a favorite stock, a CD at your bank, whatever -- and designate it as an ESA account (a process that's like opening an IRA).
PROS: Tax-free earnings with no restrictions on how you invest the money; unlike 529 savings accounts, can be used to pay for private secondary school as well as college.
CONS: Maximum yearly contribution is only $2,000 per child; eligibility depends on your annual income (in 2007, it begins phasing out at $190,000 for married couples); money must be used for education expenses or you'll pay a 10 percent penalty, plus taxes on the earnings.
BOTTOM LINE: This could also help you pay for a private K-12 education, though the contribution limits are too low to have a huge impact on any tuition bills.
Uniform Gift to Minor
Before the advent of 529s and ESAs, this was the state-of-the-art college savings option. It's simply a transfer of assets into the child's name. Up to $850 in annual earnings in the account is tax free, with lower-than-usual tax rates on returns over that limit.
PROS: When combined with a 529 account, the money in a uniform gift account will not be counted as either the guardian's or student's assets in calculating financial aid; there's also a high contribution limit ($11,000 per year per donor in 2007).
CONS: It's the child's money, so once he's 18 (or in some cases 21), it can be spent however he chooses.
BOTTOM LINE: For most parents, the benefit of having the money invisible to financial-aid analysis is outweighed by your loss of control over how the money is used.
You can, of course, forgo the various tax incentives of college savings plans and go the route of stashing your money in a mutual fund, CD, stock, treasury, or bond of your choice.
PROS: No contribution limits or penalties if you wind up spending the money on something besides higher education.
CONS: You'll have to pay taxes on dividends and interest each year; since the money is accessible, it's sometimes too tempting to tap into it for something other than college expenses.
BOTTOM LINE: If you can't afford to contribute to multiple savings accounts -- for instance, for college tuition, an emergency fund, a new house, or whatever else you're planning -- it might make sense just to save what you can in a single taxable account. But once you've built up some savings or your income increases, be sure to allocate a block of money to a true college savings account so you can get the tax benefits -- and ensure the funds don't get burned on a Caribbean cruise.
What to Look for in a 529
"There's only one catch to 529s," says Schaeffer. "You have to choose a plan, and that can feel overwhelming." After all, there are about 70 programs out there, each with its own fine print. But here are three easy steps to making the right choice:
Go to www.savingforcollege.com: You'll see breakdowns of all the important details about every 529 program out there so you can compare them -- along with links to their Web sites, where you can sign up.
Start local: If your state offers a tax deduction for contributions to its plan, there's no reason to consider any other program.
Look at fees: If your state doesn't offer a tax incentive, then choose a program with an expense ratio of less than 1 percent -- the lower, the better -- including both plan management fees and the costs of the underlying investments.
Four Creative Ways to Save
So what if you never get around to saving for college -- or if your hard-earned savings are going to fall short of the tuition bills? Here are some other ways to fund your kids' education:
Let your loved ones contribute: When family and friends ask what gifts to get her 18-month-old son, Emily Carlton, of Long Beach, California, requests a donation to his 529 account. "Why not have him receive college savings instead of presents until he's old enough to actually remember the holiday?" she says. "We have a zillion toys and clothes already; what we really need help with is saving for his tuition."
Get a campus job: Cara Halstead Cea took a public relations post at a private college near New York City because it offers free tuition to children of its staff, not just at that school but at hundreds of other institutions around the country -- a common perk of university employment.
Borrow against your savings only as a last resort: You won't pay penalties on early IRA withdrawals used for education expenses -- and you can take a tax deduction on the interest on home-equity loans used to pay the bills. "But if you spend your nest egg or burn through your home equity, you're jeopardizing your ability to retire comfortably," says Schaeffer. "Much better to send your kid to a second-tier school or let him take on some student loan debt than to do that."
Get the financial aid papers in early: From financial aid grants to subsidized loans and work-study programs, federal aid is given out on a first-come, first-served basis, so fill out the application (at fafsa.ed.gov) as early as possible in the calendar year that your kid is heading off to school, says Rich Calvario, national tuition finance consultant for TIAA-CREF, an investment company that operates 11 different 529 plans.
Copyright © 2007. Used with permission from the November 2007 issue of American Baby magazine.