Starting a college saving plan
Numbers of surveys and studies have been publishing describing how parents prepare for future college costs. Imagine your child coming to you with an acceptance letter from "the" college. The one he’s been dreaming of all through high school. That is the one, which perfectly matches to his career aspirations.
A college education is one of the best investments you can make for your child's future. However, the high cost of college may alarm you especially if you have waited too long to begin saving. For example, a Cover-dell Education Savings Account (formerly referred to as the Education IRA), with its annual contribution limit of $2,000, will not offer much help if your child is already in high school. In addition, prepaid tuition plans are attractive, but only if your child is willing to attend a school that participates in the plan.
Fortunately, there is another option for your college savings plan. Created in 1996, state-sponsored college savings plans (or Section 529 plans, after the IRS code that created them) allow flexibility in choosing a school and the opportunity for late starters to make sizable investments while reaping tax breaks.
Only one thing could make you prouder for knowing that you have done your homework, too. Anyway, where your child is accepted or what financial aid offered is not the matter, you have the resources to afford the college of choice.
You probably do not need a survey to tell you what you already know:
· Kids grow too fast.
· College is expensive.
· What is the time to start savings and planning?
Your child’s college tuition fees could be one of the largest expenditures you ever make. In addition, if you have more than one child, the financial commitment is even greater. Millions of others share the financial challenge you face.
New investment programs bring new opportunities, but they may make decisions more difficult for people who want the best education possible for the children in their lives.
Remember, even if your goal seems overwhelming now, the proper planning and saving can put the cost of any college within your reach.
Lot’s of websites analyzes the investment performance figures for thousands of 529 portfolios and ranks the 529 savings plans from best to worst for one-year investment performance, three-year investment performance and five-year investment performance.
The top performing 529 plans
Pros and Cons
Flexibility in contributions and college choice are the biggest advantages of Section 529 plans over other tax-deferred college savings vehicles. Even though these plans are state-sponsored, you do not need to be a resident of the state to participate, although you may miss state tax benefits by participating in an out-of-state plan.
Apart from tax savings, these plans offer the advantage of professional asset management. Each state contracts with a single asset management firm to oversee the plan, so by comparing various state plans, you will be able to choose from several professional management companies.
The primary drawback to Section 529 plans is investment risk. Unlike state-sponsored prepaid tuition plans, returns from Section 529 plans they are not guaranteed. This means that your investment could lose value, perhaps just as your child is beginning college. Although the firms that manage Section 529 plans use less-risky asset allocations to reduce risk as your child nears college, the risk cannot be, eliminate altogether.
You will also want to have a thorough understanding of contribution and withdrawal rules before investing in a plan, since rules vary depending on the state. Pay particular attention to rules regarding transfers, early withdrawals, or withdrawals for things other than college expenses. Penalties imposed if withdrawals are not been used for qualified higher education expenses (generally 10% on earnings only). In producing our rankings, we compared the reported investment performance of a subset of portfolios from each 529 savings plan. Lower the "percentile," much better the details on our methodology, Ranking.
1. Start Your 529 College Savings Plan Early
The earlier you start to save in a 529 plan, the more time your investments have to grow, so open a 529 plan or Coverdell Education Savings Account (ESA) as soon as possible after your child is born.
Saving for your child’s education through a 529 plan gives you the advantage of growing your money tax-free while in the plan and distributions generally not taxed if used for qualified expenses such as tuition or textbooks. Check out Sec.gov and search for “529 Plans” to learn about the types of plans available, including the Prepaid Tuition Plan and the College Savings Plan.
2. Watch Out for 529 Plan Fees
Choose a 529 plan with the lowest possible fees and without any loads. Any fees, loads, or commissions you pay to an investment adviser or mutual fund manager will eat up your returns. The best low-cost investment strategy is to find a plan offering portfolios of index funds or exchange-traded funds (ETFs). Many investors though prefer rolling savings bonds into a 529 plan just watch out for any associated fees.
3. Compare 529 Plans
Compare the features of several home state and out-of-state 529 plans to get the best bang for your education buck. Every state now has at least one 529 plan available, and each 1 can differ greatly from state to state. You should research the features and benefits of your 529 plan before you invest, compare 529 college plans at Morning star 529 Plans.
4. Get a 529 Plan Grant or Scholarship
Some states (but not all) offer tax incentives, contribution matches to 529 plan investors. For example, if you invest in a 529 plan from your home state, your state may match part of your contribution through an educational grant or scholarship. This varies from state to state, so check your state’s 529 plans and research tax treatment before investing.
5. Consider 529 Plan Alternatives
If you’re not comfortable handing over your child’s education savings to a state-based 529 plan with all their rules, fees and regulations then consider an alternative with more financial freedom.
Instead of investing in a 529 plan, put your money into a taxable account at your favorite online brokerage and invest in a portfolio of low-cost and tax efficient index funds, exchange traded funds, and CDs. Depending on your approach, the savings in fees by managing the investments yourself can more than offset the tax savings of a 529 plan. Be sure to do the calculations beforehand to determine if forgoing tax savings to preserve your financial freedom can save you money over the longer term.
A 529-college savings plan is a great way to stash some cash for school. Just be sure to compare 529 plans before signing on the dotted line
Before You Start
Talk to your child about which colleges he or she would like to attend. (State schools may allow you to prepay tuition at today's rates.)
Pull out copies of your household budget and consider ways you could spend less and save more for college.
Ask friends and family members who are currently contributing to a 529 plan for advice about making a well-informed decision.
Tax implications
One of the best ways to increase the affordability of your child’s education is to take advantage of federal tax breaks aimed at families saving and paying for college. These include the following:
Qualified Tuition Programs (529 plans) - Earnings grow tax-deferred and distributions are tax-free when used for qualified post-secondary education costs.
Coverdell Education Savings Accounts - Earnings grow tax-deferred and distributions are tax-free when used for qualified post-secondary education costs. ESAs may be the withdrawn tax-free for primary and secondary school expenses before 2013.
U.S. Savings Bonds - EE and I bonds purchased after 1989 by someone at least 24 years old may be redeemed tax-free when the bond owners, their spouses, or dependents pay for college tuition and fees. In 2011, the tax exclusion is phase out for incomes between $71,100 and $86,100 (between $106,650 and $136,650 for married taxpayers filing jointly). These income limits increase each year.
Individual Retirement Accounts - early withdrawal penalties are waive when Roth IRAs and traditional IRAs are use to pay the qualified post-secondary education costs of yourself, your spouse, your children, or your grandchildren. (Taxes may still be due on the withdrawals, however.)
American Opportunity Tax Credit - In 2011 and 2012, a parent may claim a tax credit for 100% of the first $2,000 and 25% of the next $2,000, of a dependent child’s college tuition and mandatory fees, for a maximum $2,500 annual tax credit per child. Students may claim the credit only if they are not claimed as a dependent on another person’s tax return. The credit is phase out for incomes between $80,000 and $90,000 (between $160,000 and $180,000 for married taxpayers filing jointly). The credit are allowed only for students those who are attending a degree program for at least half time and who have not completed their first four years of academic study before the beginning of the taxable year. It cannot be claimed in more than four tax years for any one student.
Lifetime Learning Credit - A taxpayer may claim a tax credit for 20% of up to $10,000 in combined tuition and mandatory fees for himself, his spouse, and his dependent children. This equates to a $2,000 tax credit. In 2011, the credit is phase out for incomes between $51,000 and $61,000 (between $102,000 and $122,000 for married taxpayers filing jointly). There is no requirement that the student be studying towards a degree or be enrolled at least half-time, and there is no limit on the number of years the credit may be taken.
Tuition and Fees - An above-the-line deduction (this means you do not have to itemize your deductions) for up to $4,000 of the college tuition and related expenses of yourself, your spouse, or your dependent is available in 2011 if your income is $65,000 or less ($130,000 or less if you are married filing jointly). For the taxpayers with incomes between $65,000 and $80,000 (between $130,000 and $160,000 for married taxpayers filing jointly). The deduction limit is $2,000. The deduction is not available if an American Opportunity or Lifetime Learning credit claimed for that student's expenses for the same tax year. This deduction scheduled to expire at the end of 2012.
Deduction for Student-loan Interest - Up to $2,500 in student loan interest may be deducted above-the-line as long as the debt was incurred to pay the college costs for yourself, your spouse, or your dependent, while enrolled as a student at least half-time in a degree program. For 2011, the deduction is phase out for incomes between $60,000 and $75,000 (between $120,000 and $150,000 for married taxpayers filing jointly). A student claimed as a dependent may not take the deduction on his or her own return.
Tax-free Scholarships - Most scholarships and grants are tax-free if the recipient does not have to provide services in exchange for the award.
Tax-free Educational Assistance - Employers may pay and deduct up to $5,250 in college and graduate school costs for each employee under a Section 127 educational assistance plan. The education does not have to be job-related. The benefit is tax-free to the employee, but cannot be use to pay for an employee’s children or other family members.
Other alternatives
Adviser-sold 529 plans
Broker-sold 529s offer definite advantages as well.
The most important benefit is that you will be receiving advice from a financial professional that can extend beyond planning for college. A capable professional will attempt to match the right 529 plans to your particular investment goals and risk preferences and help to coordinate your college planning with your other financial objectives, such as affording a comfortable retirement or minimizing potential estate taxes.
Comprehensive financial planning is no small task. In addition, financial professionals are generally not permitted to dispense legal or tax advice, their knowledge of the quirky rules and restrictions surrounding the income tax and gift tax treatment of 529 plans can help immensely.
In addition, certain mutual funds are available only through broker 529s.
Use our "Find a 529 pro" directory to find a financial planner. The planners listed here are test by us, have access to our professional-level 529 content and tools and many have attended our educational workshops. The directory includes contact information on both commissioned brokers and fee-only financial planners in your area.
Even if you feel capable of doing the research and planning on your own, you may decide that the time you save by using professional financial help is worth the cost, which typically will be either commission-based or fee-for-service. Brokers generally receive a commission on the amount you invest. Fee-only planners bill on an hourly basis or charge a certain percentage of the value of your portfolio.
Still, the question remaining, how will you finance that investment?
Pay as You Go
your child could help pay for college by getting a job, but students must already juggle studies and other college activities. Even a part-time job might detract from their primary focus – getting an education.
You can also plan to pay college expenses out of your future income as long as you realize that doing so might require substantial cutbacks in other areas of your family budget.
Pay Later
Some might suggest that you approach college tuition as you would buying a home – borrow the money to pay for college and simply repay the debt with higher earnings after graduation. Though many parents see advantages in having children contribute to their education expenses, a college education can be as costly as buying a home. How many parents want their children to start out with such substantial debt?
Find Someone to Help Pay
Scholarships and grants are the ideal financial aid. They do not have to pay back. However, according to the College Board, less then 48% of all federal financial aid comes from scholarships and grants, while the other 47% is loans (The rest is federal work-study and the value of education tax benefits.)
Save Now for More Freedom and More Choice later
saving now is the best way to ensure that you have options later. After all, you would like your child to select a college that offers the best education and not necessarily the best financial aid.
You probably also want the comfort of knowing that you won’t be dependent on outside sources like loans or scholarships to meet college expenses.
Many strategies and investment vehicles are available to help you maximize your college savings. Selecting a suitable strategy and the best combination of investment vehicles is critical. For each option, you face the task of evaluating key characteristics including:
The potential for growth
Risk of loss
Tax implications
Ownership and control
Ease of management
Set aside the cash
Although you cannot set up a 529 college savings account before your baby has a Social Security number, you can set aside some cash to start the program as soon as possible. Most plans can be start with an initial $25 to $50 contribution. You could also start a 529 plan for yourself or a cousin of the child then switch the beneficiary. Ken Nussbaum, a CPA and personal financial specialist with K. Nussbaum & Associates in Richmond, Vt., says that both options have costs and benefits.
"You may miss out on the immediate (state income) tax benefits and a little bit of growth (if you set up the account after the baby is born), but then you also don't have the extra administrative headache of changing the beneficiary," he says.
Develop a funding strategy
You cannot know what your child will want to do for his or her education before he or she is born, but you can certainly use an online calculator to get a sense of what college might cost by the time he or she is 18. You can also come up with a preliminary plan about how much you would like to contribute to the 529 plan and how far that will take you based on typical investment returns.
Compare your choices and select a plan
Years ago, most 529 plans had just a few investment options. Today, the choices can be dizzying. Now is the best time to do research on your options since you are more likely to have the time and energy to do so than when you have a newborn in the house. It is generally best to start with your own state's 529 plans. Visit the website to find out the details of the available plan as well as any state income tax breaks you might receive as a result. Also, decide if you want an age-based plan that adjusts automatically over time or a static plan that you can control yourself. If you are not happy, check out the 529, plans offered through other states.
Talk to relatives
Grandparents and other relatives are often eager to put money aside for a grandchild when he or she is born. "Grandparents might immediately think of doing something like a $1,000 savings bond," says Pietroburgo. "But this is the time you can say, 'Would you mind putting some money into a 529 plan rather than doing a savings bond?'" she says.
"Savings bonds are great but they can get lost, and a 529 really is one of the best savings vehicles for education," Pietroburgo says.
If other family members have expressed interest in doing something for the child, politely encourage them to consider a 529 plan. Sites like FreshmanFund.com allow you to set up an account to which friends and family can easily contribute.
Start smart habits
The best way to get on the right track is to begin now. You can have a small amount of money pulled from your paycheck before you even see it for college savings. In addition, commit to increasing that amount every year or every time you get a raise, says Nussbaum.
"As you get more income, it makes it a lot easier to ratchet up that amount," he says. "Psychologically, it's much easier to go from $200 a month to $400 a month than to go from $0 to $200 a month." If you start today, you will be well preparing by the time your child gets a college acceptance letter.
Establish a savings budget.
One of the first steps you should take in planning for your child’s future college expenses is to establish a savings goal. There are many very useful college cost calculators on the Internet and we encourage you to utilize them. However, you can also get rough an idea of how much you should be saving every month just by referring to the chart below. It shows the monthly savings goal from now through college graduation for a family with one child expected to enroll in the average four-year public university, the average four-year private college, or the average Ivy League college/university.
Minimize taxes.
Take advantage of the fact that your child can receive up to $950 in investment income without paying federal income tax (and at low tax rates above that amount as long as the “Kiddy Tax” does not apply). By gifting income-generating assets into a UTMA account now, or gifting appreciated assets later, you can effectively shift income and capital gains out of your higher tax bracket. The opportunities for tax savings may be even better if you can employ your child in the family business. Remember that any assets gifted to your children are theirs to control when they reach a certain age under state law, and that a student’s assets and income are count more heavily under financial aid formulas. Be sure to speak with your tax adviser before making any tax-related decisions.
Consider 529 savings programs and education savings accounts even for older children. Just because your child is already in, high school does not mean you cannot benefit from tax-advantaged college plans. If you are most recent Form 1040 shows income tax on interest, dividends, or capital gains distributions, you have the chance to save taxes with a 529 plans or ESA even if only for a few years. If your state offers a tax deduction for contributions to its 529 plan, you might even benefit by opening an account and soon thereafter start taking distributions to pay college bills.
Invest tax-free whenever possible. If your child will be attending a private, religious elementary, or secondary school, consider opening an ESA and contributing up to $2,000 per year. However, the K-12 exclusion ends after 2012. If your child still has money in the ESA after high school, it can then be use tax-free for college.
Create the right asset mix between your taxable and tax-free investments. If you maintain a taxable investment portfolio and a 529 plans or ESA, concentrating the growth portion of your investments in the taxable accounts and the income-producing portion in your 529 accounts or ESA. Growth stocks and low-turnover equity mutual funds are already tax-efficient, can take advantage of low capital gains rates, while income-producing investments are less tax-efficient, and can benefit from the tax shelter of a 529 plans or ESA. Capital losses in a taxable investment can also provide a tax benefit, while a 529 plans or ESA cannot produce a capital loss (only a miscellaneous itemized deduction if fully liquidated).
Put the right person in control. Grandparents using a 529 plan to save for a grandchild’s college education should open the account in their names if they want to maintain control and retain the ability to change the beneficiary to another grandchild. However, if the grandparents prefer that the parent control the account, they can simply contribute into the parents’ 529 account (assuming that particular 529 plan accepts contributions from a non-owner). Another easy way to “gift” a 529 plans contribution into an account for a grandchild is to make the check out in the name of the 529 plan and hand the check to the parent who can make sure it is contribute on behalf of your grandchild.
Consider professional assistance. We suggest you consult with experienced and knowledgeable financial, tax, and/or legal advisers about all the matters discussed on these pages. The issues are complex. Be aware that for some financial advisers, 529 plans and ESAs are a new phenomenon. If you are working with one, ask which particular 529 plans are available through the adviser and what makes one 529 plan better than another does. In interviewing prospective advisers, you might even ask whether they have opened their own 529 accounts. It helps to know that the professional you are relying on has personal experience with 529 plans.
Be flexible with your college planning. Programs and investments will continue to evolve. Tax laws will change and so will your own circumstances. Review your financial situation periodically and make adjustments whenever it seems appropriate.
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