Smart New Ways to Save for College
There is no better financial investment parents can make towards their child's future than to plan for his or her college education. Confused about college saving plans? Here's the scoop!
The Cost of College
Nationwide, the price tag of higher education is rising at an alarming pace. During 2005, the tuition of a four-year public college increased on average 7.1 percent for tuition and 6.2 percent for room and board, and is rising much faster than the national average for wages and most other expenses. According to the College Board, a nonprofit membership organization, the average cost for a year of college—including tuition, books, and transportation—is $15,566 for in-state public colleges and $32,070 for private colleges.
Even with these daunting statistics, there are many available options for parents as they plan and save for college. One of the most important opportunities for parents of babies and young children is time. Ira Langer, sales manager at New England Financial, advises, “Parents should start saving early so that they can be somewhat aggressive in their investment choices and provide themselves with a better opportunity to achieve higher returns.” As with most financial plans, good investment strategies and time are the winning combination.
To estimate how much money you’ll need to send your child to college and how much savings will be required either monthly or yearly, try an online college savings calculator such as the Saving for College website. This calculator allows you to input key information and determine whether your savings will cover future college costs. Additionally, it has a tuition search feature that shows current annual costs at various colleges nationwide and allows you to print a customized report that summarizes the information for you.
The next step is to review educational plans that can help you maximize your savings and then choose the type of savings plan suitable for your family.
Fast becoming one of the most popular ways to save for college, 529 plans are state-managed investment accounts open to anyone, regardless of residency or income level. In a 2004 survey conducted by the Investment Company Institute, the national association of US investment companies, 63 percent of parents would choose a 529 plan over a Coverdell Educational Savings Account if they had $2,000 to save for college. One reason for making this choice is the flexibility that a 529 provides.
Funds from a 529 plan can be used for any qualified education expenses, such as tuition, room and board, fees, and books at most accredited public or private colleges, universities, community colleges, and graduate schools. Depending on the state, some plans will allow funds towards vocational and international colleges. Additionally, 529 plans allow large contributions, unlike other plans with annual caps. Another flexible feature is that the account holder controls the money for the duration of the account even after the beneficiary turns 18 and allows parents to change the beneficiaries of the plan.
Most parents prefer the tax treatment of 529 plans. Earnings and withdrawals are federal tax-free, and you can contribute up to $11,000 annually without paying gift tax. Most 529 plans do not impact a student’s ability to receive financial aid, as savings are treated as an asset of the parent instead of the student, and only 5.6 percent or less is used to calculate the Expected Family Contribution (EFC).
Because 529 plan accounts are managed for you, there are account manager fees that can be as much as one to two percent of annual earnings. Another downside to consider is your tolerance for risk; these plans are not guaranteed to make a profit and are subject to the highs and lows of the stock market. Always make sure you choose your investments in a 529 plan with your risk level in mind. The tax benefits could cease in the future as federal tax exemptions on withdrawals may expire by December 31, 2010, unless Congress extends them—and it is likely that it will. Before investing in a 529 plan be sure to compare various investments and plans.
Prepaid College Plans
These plans, also known as Prepaid Education Arrangements, give families the advantage of locking in public, in-state college costs at today’s prices. The plans vary in cost depending on how many years you have before your child goes to college, so the earlier you get started the better.
The prepaid college plan is recommended if you prefer a guaranteed, low-risk savings plan. The risk involved is minimized due to the value of the investment being guaranteed by the state to meet the costs of the annual in-state public college tuition. Most plans allow a student to attend out-of-state colleges but only fund at the in-state college rate, with parents paying the difference. These plans also offer tax-free benefits on qualified withdrawals. Prepaid college plans are becoming more attractive to compete with the various other savings plans available.
Drawbacks to prepaid college plans include limiting participation to state residents. Another disadvantage is that room and board costs may not be covered. Depending on the state, some plans only fund tuition and fees, while other plans allow excess funds to be used for room and board, or they have a separate room and board plan.
For example, the Florida Prepaid College Plan offers three different tuition plans, a fee plan, and a dormitory plan. The tuition plans include a four-year university, a plan that covers two years community college and two years university, or a two-year community college plan. The dormitory plan pays for the cost of a standard, double-occupancy dormitory room at a Florida university or other university-held housing, but it is only available for children in the eighth grade or younger. Also, most universities designate certain dormitories to Florida prepaid students and there is no guarantee that the student will receive a room as it is assigned on a first-come, first-serve basis.
Another potential disadvantage is that some states have penalties for canceling the plans, including cancellation charges and/or loss of interest. Some plans do not have cancellation penalties, and parents can get a refund for any reason. Be sure to check with your state’s prepaid college plans to learn more.
Coverdell Education Savings Accounts
The Coverdell ESA plan, previously known as the Education IRA, was redesigned to give parents another option for educational savings, including elementary and secondary schools. Coverdell ESAs are similar to a Roth IRA but are geared specifically to education costs. They can be used in combination with the 529 plan or prepaid college plan, but currently $2,000 is the maximum annual savings that can be contributed.
Though these accounts provide similar tax-free benefits, they are not as flexible as 529 plans due to the low contribution limit and because law prohibits ESA funding once the beneficiary reaches age 18 (the money will be subject to tax penalties if not fully withdrawn before the student turns 30).
Another disadvantage is the contribution has to be distributed to your child even if it is not used for college—and you cannot refund the account back to yourself as you can with most 529 plans. Withdrawals may be fully tax free but limited by taking other tax deductions such as the Hope or Lifetime Learning credit. Similar to the 529 plans, tax advantages will expire in 2010 unless voted otherwise in Congress.
Other Savings Tools
Though not as popular as the three main types of investments, the government-issued savings bonds series EE are geared towards education. These bonds are purchased at a discount and accumulate interest over the years to maturity. The proceeds, both principal and interest, are tax free if used for educational expenses. Anyone can purchase these bonds for a child.
Upromise, a totally free savings tool, allows parents, grandparents, and even friends to accumulate savings by purchasing certain items in grocery stores, online, in restaurants, and more—and accumulate free money towards a child’s education expenses. While Upromise may only provide for a small amount, it could pay for items such as books and supplies. You can check it out at www.upromise.com to review the details and sign up.
Different investments work for different families. The most important goal and the first step towards your educational financial security is to create a plan to save for your child’s future.
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