If you've just recovered from the sticker shock of stroller prices, brace yourself, because you're about to learn the cost of college. In 2020, four years at a public university will cost about $118,000; private tuition will run around $260,000, according to estimates from T. Rowe Price Associates in Baltimore, a mutual fund company that manages three state college savings plans.
But saving a little bit each month starting now could add up to a significant chunk of change by the time your child goes to college. Consider this: $100 invested monthly in a 529 college savings plan could grow to $30,500 in 18 years.
Given the recent state of the stock market, investing may seem even scarier than those future tuition bills. But even with the Dow Jones Industrial average dropping, historically, stocks have still beat money market accounts when it comes to returns. If you look back over the last 20 years, a time frame that includes some of the steepest market declines, "the stock market has still grown on average about 8 percent each year," says Jay Stillman, a certified college planning specialist as Savingforcollege.com. Money markets, meanwhile, have grown just 4 percent. According to Stillman, it's short-sighted to base your concerns on a market's most recent performances. Instead, it's most important to invest over time so you're likely to reap a solid average return.
And even if your child goes to the most expensive school in the country, it's reasonable to assume that if your household income is below $70,000 a year, your child will be eligible for some sort of financial aid, which usually consists of student loans. The key is simply to save as much as you can on a regular basis. And because you can open most of these college savings accounts with as little as $25, don't wait another second to start. As anyone who's forgotten to record milestones in a baby book knows, time flies -- and it only gets harder to catch up.
Section 529 plans are state-sponsored mutual funds that allow you to invest in the financial markets for the exclusive purpose of saving for college, without having to pay taxes on your earnings, explains Stillman. Normally, if you make money on any investment -- including real estate -- you have to pay capital gains taxes. The amount of these taxes can be anywhere from 8 to 20 percent of your earnings.
Another benefit of 529s is that in most cases, they won't hurt your child's chances of getting financial aid. A major factor in financial aid is how much money is set aside in the student's name; the more money he has, the less likely he is to get aid. These accounts designate the parent as the owner of the account, so the money is deemed a parental asset, which carries less weight in determining aid.
To offer 529 programs, each state has partnered with an investment firm that sets aside one or more mutual funds exclusively for college savings, says Stillman. If your child decides to forego college, you can transfer the money to another child. However, it has to be used for someone's college expenses only, or else it's subject to taxes plus a 10 percent penalty, warns Steve Vitale, a certified financial planner at J.B. Hanauer & Co. in Parsippany, New Jersey.
You can invest in any state you want, but many states offer tax advantages to residents who keep their money close to home. For example, some states will let you deduct the amount of your yearly 529 contributions from the amount you owe that year in state income taxes. Conversely, investing out of state could cost you some tax penalties.
A 529 plan can be made up of stocks, bonds, or a combination of both. Some states even have age-based mutual funds that give high-risk, high-return stocks to people whose young children have time to spare before college starts. The money is automatically transferred to safer securities as the child gets closer to college age.
There's always a risk when you decide to invest in the financial markets. Sure, that risk is lower if you keep the money in longer, but gains are never guaranteed. What's more, all 529s are not created equal, says Vitale. It's like any investment -- it's important to take the time to do your homework. For example, in the last quarter of 2002, on average, Illinois' plans yielded about 4 percent. Other states, such as Massachusetts, wound up in the negative numbers.
While historical rates of return are not a guarantee of future 529 performance, they can give you some indication of the company's track record. Vitale suggests asking either your financial adviser or the 529 management company about the fund's past performance. Also, review the management's brochures so you know who's handling your money. You may also want to consider seeking the advice of a professional financial adviser; it may cost extra now, but it's likely to pay off in the long run.
Another potential issue with the 529 plan is that it may be retired in September, 2010, well before today's toddlers are filling out application forms, says Kalman Chany, author of Paying for College Without Going Broke (Princeton Review). There's no way to know what Congress will decide in 2010, but many financial experts are betting it will renew the program, because making it more difficult to save for college would be an unpopular decision. Chany, meanwhile, isn't so sure. If the law expires before your child is in college, you'll have to pay taxes on all that money.
You only need $25 to open an account in most states. And each parent can contribute as much as $55,000 every five years, says Vitale. Over the life of the plan, you can give between about $140,000 and $350,000, depending on which state you've selected. First, contact your state treasurer at www.collegesavings.org to find out which investment company is running the program, and research other states at Web sites such as Savingforcollege.com or 401kid.com. Before making a decision, be sure to review the historical performance of the fund and find out about tax penalties and benefits.
Prepaid tuition plans protect you from skyrocketing college costs by charging you today's rates -- in small installments -- for an education later on. That means if you paid $10,000 for tuition in 2003 and the tuition grew to $15,000 in 2020, you wouldn't have to pay the $5,000 difference when your child entered college. You can sleep at night because your child's education at a public, in-state school is guaranteed to be paid. What's more, the plans will let you use the tuition at any in-state school, from selective universities to community colleges.
Your peace of mind is expensive, warns Chany. Prepaid plans only help you keep pace with tuition inflation, which has historically grown at about 5 percent per year. Despite cyclical highs and lows, the stock market has grown 8 percent per year, on average, so you could miss out on some financial gain.
And if your child decides to forego State U. for an out-of-state or private school, you can still pay his tuition with the prepaid 529 money, but you'll have to pay the difference in tuition, which could amount to tens of thousands of dollars. A prepaid plan will also hurt your child's chances of getting financial aid for costs such as housing because it's in your child's name.
Monthly payments can be as low as $25, depending on the school's yearly tuition. Find out what's offered in your state by calling the National Association of State Treasurers at 877-277-6496 or visiting www.collegesavings.org.
Coverdell accounts, formerly known as Education IRAs, allow your money to grow tax-free in investments of your choice, says Stillman. Coverdells offer a wide range of investment options, including individual stocks and bonds, mutual funds, and other financial tools you may want to consider. Essentially, they're like any other investment, but they require additional paperwork.
Coverdell accounts are a good option for those who want spending flexibility. Unlike other college savings plans, Coverdell savings can be used for all kinds of educational expenses, such as private high school or even preschool.
Your money will still be at the mercy of the financial markets, which can grow and deflate with the economy. These accounts may also interfere with your ability to get financial aid because they're in your child's name. If you make more than $110,000 as a single parent or $220,000 as a married couple, you can't participate in this tax break. And the most you can contribute to them is $2,000 per year, which is a good start, but hardly enough to pay for college in its entirety, says Stillman.
You can open most accounts for $25 at a variety of banks, brokerage firms, investment institutions, and credit unions.
When you buy savings bonds, you're lending money to the government, explains Stillman. The government, in turn, pays you back double the amount you gave, plus about 3 percent interest, depending on market conditions. It hardly happens overnight, though. You have to wait 17 years until the bonds fully mature to cash them in for their maximum value. But if you use the money for college, you won't have to pay any capital gains taxes on it if you're a married couple whose household income is less than $116,400 or a single parent making less than $72,600.
If your income is over the allowable amount, you're taxed the regular capital gains tax for your tax bracket. But if your income grows with your child, you can always place the money directly into a 529 plan and bam -- it's tax-free again, Stillman says.
While these bonds are the safest bets around, the returns are low and probably won't help your money keep up with the fast pace of tuition inflation, points out Chany.
You can buy Series EE savings bonds in denominations of $50, $75, $100, $500, $1,000, $5,000, and $10,000. But because you front only 50 percent of the face value, you pay $25 for a $50 bond, $50 for a $100 bond, etc. Then, when you cash in, you also earn interest at a rate that changes with economic conditions. So even if the interest rate is lackluster, you will still see 100 percent growth in your money. You can buy Series EE bonds directly from the government by going to any financial institution.
Like Coverdell accounts, the only thing that separates UGMAs from regular investments is the paperwork. You can invest in a wide variety of financial options, plus you can sock away an unlimited amount of money for your child each year.
The tax benefits on these accounts are limited; if you save more than $1,400 in one year, you must pay taxes on the money. If you save more than $11,000 in any given year, you have to pay a gift tax of 25 percent or more, explains Brian Orol, a financial planner who runs 529college.com. And because this money isn't specifically earmarked for education and is placed in your child's name, he's entitled to use any and all of it on whatever he wants when he reaches the age of majority (18 in some states, 21 in others). In other words, your child could use it to start a business venture, or he could blow it all on a cross-country motorcycle trip, warns Vitale. The parent loses control of the assets, so for some families, it's not the best choice.
You can open these accounts with as little as $25 at any local bank, brokerage firm, or credit union.