If you have children, how should you prepare for their college expenses? By first funding your retirement adequately, and then saving for college expenses. It’s much easier for a child to find financing for college than for you to find financing for retirement. Students can get loans and sometimes grants or scholarships. A retired person should avoid borrowing, and there are no scholarships for retirement. You should support yourself first. A child who is determined to go to college will usually find a way to finance it. School loans feel like a burden, but supporting a destitute parent is likely to feel like a bigger burden. Don’t be a burden on your children.
U.S. Savings Bonds can be used by middle income people as a tax shelter for college savings. Money from savings bonds used for college expenses is not taxed if you fall below the income limits. Savings bonds might be especially useful for if the child is only a few years away from beginning college. You avoid the risk of the potential volatility of stocks, and ensure that the money will be there when your child needs it. The interest rates are low, but the money is safe. If you don't use the money for college expenses, you can keep it for retirement.
529 Plans are potentially useful as tax shelters for college savings. There are two types of 529 Plans: the 529 Savings Plan and the 529 Prepaid Plan. But don't assume that the tax advantage supersedes other considerations. Watch out for high costs and fees; they can seriously erode what you gain from the tax benefits of a 529 Savings Plan. Also, keep in mind that there is an exit strategy problem if the kid doesn’t go to college, or starts but then drops out. You can get back the money left in the account only after paying income taxes and a 10% penalty on it.
Coverdell ESA’s are also tax shelters for educational savings and offer more flexibility than 529 Plans in their investment choices. But persons at higher income levels can’t use them and they have miserly contribution limitations. They also have a worse exit strategy problem than 529 Plans in case the kid doesn’t go to college or drops out. The kid (not you) gets the money at age 30 (subject to payment of income taxes and a 10% penalty).
Plain old savings in low cost taxable investments aren’t a bad way to save for college costs, and can also serve as part of your retirement savings plan. When you compare some higher cost 529 Plans against a low cost taxable investment, the taxable investment may come out ahead. Further, taxable savings have no exit strategy problem since they can be used for retirement without penalty and you've already paid the taxes on them.
UGMAs are falling out of favor. They're losing some of their advantages and other savings tools are easier to use.
If you’re a late-in-life parent, or a grandparent with a dependent grandchild, use Social Security to provide college funding. No, we’re not kidding. A dependent child or grandchild of a person who’s collecting Social Security is also entitled to benefits. The benefits aren't specifically meant for college costs, but you can save up the child’s benefits for that purpose.
Federal financial aid rules don't give an advantage to one kind of savings vehicle over others. But individual colleges may have different standards for measuring financial need.
When it comes to saving for college, there isn't a simple solution that's best for everyone. But we offer a few thoughts for how to look at the problem.
Next to their homes and their retirements, the largest financial question most parents face is how to deal with the cost of college educations for their children. Household economics tend to answer the question for most parents: they don’t make enough money to pay for all of the kids’ college expenses, so everyone does their best with scholarships, grants, loans, summer and part-time jobs, as well as parental contributions. There is no simple answer, and there are a number of considerations.
Don’t Be a Burden on Your Children
This may seem like a strange way to begin discussing the burden that kids’ college expenses place on parents. But if you sacrifice a great deal of your money to paying for your kids’ college educations, and then can’t adequately fund your own retirement, you could end up being a burden on your children. That could come at a time when your kids are struggling to pay their mortgages and raise their own children. The cost of helping you could make things worse for them.
Prepare adequately for your own retirement. If your financial situation turns out well, you can always use some retirement assets to pay for your kids’ educational expenses.
Okay, You Think You Can Save for Retirement and for College Expenses
Naturally, a lot of parents try to save both for retirement and for their kids’ college educations. There are a variety of ways of doing this, including using tax sheltered college savings plans, and putting assets in the child’s name. The tax advantage of putting assets in the child’s name is less valuable after recent changes in the law, and assets in the child’s name could result in less favorable treatment for financial aid purposes. You should also think about whether or not you want your child to get control over a substantial amount of money at age 18. Some kids will be very responsible, and other kids will soon drive a nicer car than yours. You may not be sure which category your three-year old will fall into.
Keep in mind that many students need five or six years to finish college these days. Some of them take a year or two off, and work. They may not need support during that time. Others may be continuously enrolled as students and may need your help for all that time. Be aware that perhaps only half of all college freshmen receive their degrees four years later, and that you may have to save more than you expected.
We can’t begin to cover the subject of financing a child’s college education in its full glory. Entire books and websites are devoted to the subject. While federally sponsored financial assistance is the largest source of student financial aid, remember that financial aid can be found in a variety of places. Your child’s high school, or hometown civic organizations, may offer scholarships. The college that your child attends may offer scholarships, work-study programs and other forms of assistance. The individual department for your child’s major may control the spigot on some scholarships and fellowships. Your child could find a part-time job on his or her own—some kids wash dishes and flip hamburgers to pay for their educations. These jobs may be the best experience, because they carry no hint of a handout or make work. They are real jobs that the child holds (or not) based on his or her abilities and performance, and provide a crucial step toward adulthood.
However, since this website is about saving, two college savings plans are discussed below. First, it’s important to remember that you don’t have to put college savings into a special plan. Many people don’t. You might think about puting some money into college plans, but not necessarily every dollar that might be needed for an expensive private institution. If the child doesn’t go to college, or starts but then drops out, retrieving the money in educational savings plans for other purposes, such as your retirement, is either costly or impossible. Thus, we'll also discuss alternatives to college savings plans. We begin with an alternative: U.S. Savings Bonds.
U.S. Savings Bonds can be used tax-free to pay for a child’s higher educational expenses if your income falls within certain limitations (in 2007: $65,600 for single parents and $98,400 for married couples filing jointly; with partial tax breaks for single parents making up to $80,600 and married couples filing jointly making up to $128,400). The inflation adjusted I-Bonds might be a good choice here, since you’ll have protection against inflation as well as some interest income. The bonds can also be used for your retirement (although you'll have to pay income taxes on the interest and, in the case of I-Bonds, on the value of the adjustments for inflation). Savings bonds may not produce gains as big as the stock market’s gains, but unlike the stock market they won’t generate losses. If you have less than 10 years to save for college expenses and your income falls within the levels where you can get a tax break, Savings Bonds may be a good choice. They are direct obligations of the U.S. government, which means they are safe.
Savings bonds can be purchased at most banks and other financial institutions, through payroll deduction and from the U.S. Treasury at a website called Treasury Direct (www.treasurydirect.gov).
The 529 Plan has become a highly visible choice for college savings. The 529 Plan is usually sponsored by a state, and comes in two flavors: the savings plan and the prepaid tuition plan. There are dozens of 529 Plans and they are not all the same. We furnish a general description of the 529 Plans, to give you an idea of what they involve. But check out the details of any particular plan you’re considering. Pay close attention to the costs and fees of the plans, which vary quite a bit. As always, high expenses eat into investment returns in a way that compounds negatively over time, so look for a low cost plan. If all of the investment choices in the 529 plan are high cost, you may actually be better off saving in a regular taxable account (see our comparison below).
A 529 Savings Plan allows you to save after-tax dollars without paying ongoing income taxes on the interest, dividends and other investment returns. Thus, the funds in the account grow on a tax-free basis. Some states even allow you to deduct contributions on state tax returns (there are no federal deductions). If you use the money in a 529 Savings Plan to pay for the tuition, room, board or other college expenses, there is no income tax on the withdrawals. Withdrawals of the account’s earnings for other purposes—like your retirement--are subject to state and federal income tax, plus a 10% penalty; there are limited exceptions to the 10% penalty. You retain control of the money. That means the kid can’t take it at age 18 and buy a sports car. The money in the plan can be used at any accredited university or college; it’s not limited to just the public university of the state sponsoring the plan. You have to invest the money in a limited number of options specified by the particular Plan you select, so make sure you like the options offered (and that they have low fees and expenses).
One significant advantage of the 529 Savings Plan is that persons at all income levels can have one. The other tax advantaged educational savings plan we discuss here, the Coverdell ESA (see below), is not available to people whose income exceeds certain specified limits.
The limitations on contributions to 529 savings plans are generous. You can contribute up to the gift tax limit per year ($12,000 individually, or $24,000 for a married couple), and you can “prepay” five years at a time (i.e., contribute $60,000 now or $120,000 for a married couple but with no further contributions during the next four years). Some plans allowing lifetime contributions of $200,000 or more.
A contribution to a 529 Savings Plan is treated as a gift to the child for the purposes of the gift tax. If you make a contribution exceeding the annual limit (such as a prepaid contribution), consult with a tax accountant or attorney because there could be federal and state tax consequences for large contributions to a 529 Savings Plan—a gift tax filing would likely be required and it’s even possible that you might have to pay gift tax depending on what other gifts you have given. Furthermore, see the discussion below about the exit strategy problem. It’s not necessarily wise to contribute the maximum allowable amount in the plan.
You can generally invest in any state's 529 Savings Plan regardless of where you live, but choosing the right plan isn’t easy. There are many dozens of them, and their performance histories, costs and expenses vary greatly. In fact, their costs and expenses can vary within a particular plan, depending on the investment options it offers. Be particularly careful if a broker is selling you a 529 Savings Plan—the plan will probably pay the broker a commission, which will come out of your investment in the plan and add to your costs.
If your home state offers a deduction for contributions to its 529 Savings Plan, you’ll get a modest tax benefit. For example, if you contribute $5,000 to the 529 Savings Plan offered by your home state and your marginal state income tax bracket is 6%, you will save $300 in state income taxes. But if your state’s 529 Savings Plan’s investment options have high fees and expenses (e.g., 3% a year of the assets in your account), the $300 in tax savings could be offset by fees and expenses within a few years, when the account is compared to a low cost 529 Plan in another state (such as one with fees and expense of less than 1% a year). This is because you get the deduction only once, but the fees and expenses are imposed every year. The lowest overall cost is what is important, so don’t assume that the availability of a state deduction determines which plan to use.
One way to search for a plan with low fees and expenses is to use the plan comparison feature at www.savingforcollege.com. While we have not tried to do a comprehensive analysis of all 529 Savings Plans, the Utah Educational Savings Plan (UESP) Trust, the Virginia Education Savings Trust, South Carolina’s Future Scholar 529 College Savings Plan (Direct-sold) and New York’s 529 College Savings Program—Direct Plan appear to be low cost plans. Note that these low cost plans are direct sold (i.e., you would contact the plan itself to invest; brokers don’t sell them). Direct sold plans have much lower costs because they don’t pay commissions to brokers. Some states have more than one 529 Plan, with widely varying fees and expenses, and you need to make sure you correctly identify the plan with low costs. Other plans not specifically mentioned here may also be low cost, so do your research.
The second type of 529 Plan is the Prepaid Plan. It allows you to pay today for your child’s college tuition in a public college or university of the state sponsoring the plan, regardless of the child’s age. The state sponsoring the plan usually guarantees that the tuition costs are covered (although some states do not literally guarantee coverage—read the fine print of each plan because some plans only say that the state legislature will consider covering shortfalls; and a few plans don’t offer any guarantee). Perhaps one 529 prepaid plan (Florida’s) also covers room and board, but most do not. This means that you still have to save for room and board even if you prepay the tuition. You or your child must usually be a resident of the state sponsoring the prepaid plan if you want to participate.
The amount you pay may depend on factors such as the age of the child and the state’s current tuition charges. You shouldn’t be surprised if the state charges more than current tuition rates, because the plan might need a financial buffer. In other words, the prepaid plan takes the risk of tuition increases off your hands and puts them on the plan. Some plans may want extra money as a reserve to cover the risk of large tuition increases.
The value of your prepaid account grows, in essence, at the rate of increase of college tuition. This increase is not taxed while it is accumulating, and is not taxed if the funds in the account are used for educational purposes. You do not get any federal deduction when you buy prepaid tuition, but residents of some states may get a deduction from their state income taxes if they participate in their home state’s prepaid plan.
If your child does not attend a state school covered by the prepaid plan, the value of your assets in the plan can be used to pay for his or her attendance at another school. However, you may not be able to retrieve the full value of those assets. Read the fine print for any prepaid plan you consider.
There is an Independent 529 Prepaid Tuition Plan for people who think their children will go to private colleges. About 250 private institutions participate in this plan. Many are among the top colleges in the nation. Many other top colleges do not participate in this plan. This plan is expensive compared to prepaid plans for state institutions. Private schools are much costlier than public schools, so prepayment of their tuitions would naturally be more expensive than prepaying state university tuition. The Independent 529 Prepaid Tuition Plan only covers tuition and fees, so you still have to save to cover room and board, and other costs.
Investing in a 529 Prepaid Plan gives you some peace of mind when it comes to tuition and fees (and room and board if the plan covers them). But it would not give you that much ability to tell your child, “go to the college you want.” If the child chooses a college not covered by the prepaid plan, your ability to finance his or her education could be diminished rather than enhanced, because some states would not let you retrieve the full value of your account in the prepaid plan. A child who can read at age 4 and appears to have academic promise may, by age 17, have strong artistic bents and want to go to film school. Will the film school, which you never anticipated, be covered by the prepaid plan? Predicting your child’s life is no easier than it would have been to predict yours. (Think about that!).
The exit strategy problem: what if money in the 529 Plan isn’t used for education?
Kids have to, and eventually will, find their own way in the world. The college and graduate school march to professional glory that you may envision for the little one won’t necessarily happen. If not all of the money in these plans is used for higher education, extracting the unused portion usually will involve a penalty of 10% of the earnings, plus payment of federal and state income taxes on the earnings. Further, if you took a deduction on your state income tax return for a contribution, you will probably have to “undeduct” (the technical tax term is “recapture”) the unused amount you retrieve from the plan. That means you’ll have to reimburse the state for the value of the deduction you took for the money that is not used for an educational purpose. (Deduction recapture involves more forms to fill out at tax time and is a boon to accountants; but most people would rather chug horseradish straight up than recapture deductions.)
Prepaid tuition plans may be especially unforgiving if you want to withdraw the money instead of using it for educational purposes. The interest earned on the principal may be reduced or not given to you at all, and there sometimes are penalties. You may be able to shift the student designated for the plan from one of your children (the unscholar) to another. But ultimately, if the account is not used for educational purposes at institutions covered by the plan, there can be severe limitations on how much you get back. You should check out your exit strategy extra carefully if you invest in a prepaid tuition plan.
The difficulties of retrieving money not used for education in a 529 Plan should lead you to think carefully about using one. About half of the kids that graduate from high school go onto college. If you’ve gotten this far in this website, chances are your kid(s) will be among them. But then something like one-third to one-half of all kids entering college don’t graduate. That doesn’t necessarily mean they are failures. It may, however, mean that you’ll have excess funds in a 529 Plan that won’t be used for educational purposes. You can’t get your hands on that money without paying income taxes and the 10% penalty on earnings.
529 Plan vs. Taxable Savings (a tight race)
Because of high fees and expenses, the returns on many 529 Plans aren’t stellar. Compare the returns that can be expected from the 529 Plan(s) you’re considering against a low cost ordinary taxable investment account. The latter may be used for educational expenses, or for retirement without penalty, as you choose. Of course, you’ll have to pay income taxes along the way. But if you select low cost, well-diversified investments for the taxable account, you may not do badly in comparison to some 529 Plans. This may be especially true for a taxable account invested in index funds or other funds that have low fees and expenses and strive for tax efficiency (i.e., they manage their investments to minimize tax liabilities for investors). The numbers can tell a story.
For example, let’s assume a married couple in the 28% federal tax bracket and 6% state tax bracket puts $10,000 a year into a 529 Plan for 18 years. Further assume that, because of high fees and expenses, the 529 Plan yields a return of 5% per year. Using the cnn.money.com Savings Calculator available at cgi.money.cnn.com/tools/savingscalc/savingscalc.html, we get a total of $281,324 at the end of 18 years. (That seems like plenty, but college educations could cost that much or more in 18 years.)
We’ll next assume that, if this couple saves the same $10,000 a year in a taxable diversified mutual fund with low fees and expenses, they’ll get a return of 7% a year. The 2% difference between the high cost 529 Plan and the low cost taxable mutual fund is quite plausible. Some 529 Plans can have expenses as high as 3% a year, and some inexpensive mutual funds can have expenses below 0.5%, which results in a difference as wide as 2.5% or more a year. Saving $10,000 for 18 years in the taxable account at a yield of 7% a year produces $298,846. The taxable account provides $17,522 more than the high cost 529 Plan, and its assets can be used for education or for retirement without penalty or further taxes.
Even if we assume that the cost difference between a 529 Plan and a taxable account is closer, you can still be caught in an exit strategy problem if not all of the money in the 529 Plan is used for higher educational costs. Consider the case if the couple using the 529 Plan has a return of 6% a year, instead of 5%. This would be only 1% less than the returns in the taxable account. At the end of 18 years, that couple would have $309,057 in their 529 Plan. That's about $10,000 more than they'd have with a taxable account.
The 529 Plan is better than the taxable account if you spend it all on educational expenses and thereby avoid taxes and penalties. But what happens if you spend only half of it, $154,529, on education (either because your kid drops out of college, or because your kid’s college was comparatively inexpensive, and you are left with surplus funds)? You now want to use this money for retirement. You have $154,528 remaining. Of this amount, $64,513 consists of earnings, which are subject to taxation and a 10% penalty if not used for educational purposes. Subtract the 10% penalty ($6,451) and combined state and federal taxes of 34% (or $21,934) for a total reduction of $28,385. You are left with $126,143. (If you took any state deductions, you’d have to undeduct, or recapture, them, which would only add to the costs of exiting.) If you had paid for the kid’s educational expenses from the taxable account instead, you’d have $144,317 left, free and clear of income taxes and penalties. In other words, using the low cost taxable account, instead of the tax sheltered 529 Plan, puts you $18,174 ahead of the game. A low cost taxable account can beat a high cost 529 Plan. Look at costs closely before deciding which way to save.
Coverdell Education Savings Account
A Coverdell account is another tax-advantaged savings account for educational expenses. Like a 529 Plan, you contribute after-tax dollars to the Coverdell account and its interest, dividends and other investment returns compound tax free. The Coverdell account is much more flexible than a 529 Plan when it comes to investment alternatives. It can be opened with a mutual fund management firm, a brokerage firm, or another financial institution. The potential range of investments for a Coverdell account includes almost anything under the sun except for insurance products. This will make it easier to find low cost investment choices. The earnings of the Coverdell account grow tax-free and are never taxed if used for educational purposes. They can be used for private elementary and high school expenses, as well as college costs (whereas the 529 Plan is for college only).
The disadvantages of the Coverdell are, first, they are available only to persons whose income does not exceed certain limits: $110,000 for singles and $220,000 for married couples filing jointly. The maximum contribution permitted is $2,000 a year, and this amount gradually diminishes for single taxpayers whose income is between $95,000 and $110,000, and married couples filing jointly between $190,000 and $220,000. Contributions cannot be made after the child designated the beneficiary of the account reaches the age of 18.
Second, Coverdells also have an exit strategy problem. If money in a Coverdell is not used to finance education, it ultimately goes to the child named as the beneficiary of the account at age 30 (after federal and state income taxes are paid, along with a 10% penalty). The designated beneficiary can be changed to another of your children (or certain other relatives) if there are excess funds in the account that the original beneficiary won’t need for education. This would be a way to preserve the funds for educational use. But if the original beneficiary assumes control of the account after becoming a legal adult, you might need the original beneficiary’s consent to a change of beneficiaries. Any new beneficiary would have to be under 30 years of age. Eventually, if funds remain unused after you run out of eligible beneficiaries, the unused funds go to the last beneficiary.
Another feature of the Coverdell is that if you make tax free withdrawals from a Coverdell, you cannot take a Hope or Lifetime Learning Credit on your federal income taxes for the same expenses as were covered by the withdrawal from the Coverdell. Another way of saying this is that you can’t get a federal tax benefit twice for the same educational expenses. Hope and Lifetime Learning Credits are tax credits for middle income persons (available to taxpayers earning $57,000 in 2007, for a single parent, and $114,000 in 2007, for a married couple filing jointly). See the IRS’s Publication 970, available at www.irs.gov, for more details.
Educational Accounts at Tax Return Time (you know from the heading that this won't be fun).
If you have a Coverdell and a 529 Plan, you have to coordinate the withdrawals from the two so that you don’t exceed the maximum amount of permissible educational expenses that can be paid from these accounts. Basically, those expenses include tuition, fees, room and board and required books and equipment. Make sure you have good records proving what these expenses were, in case you're audited. If your withdrawals exceed the total of these amounts, the excess is subject to federal and state taxes and a 10% penalty. See the IRS’s Publication 970 for a bigger headache and more detail about how to calculate the tax free and taxable amounts of the distributions from educational accounts.
If you’re starting to get the uneasy feeling that the bookkeeping and tax return work needed for withdrawals from 529 Plans and Coverdell accounts would put a strain on your antacid and painkiller budgets, you’re right. People who have an affinity for mind numbing arithmetic detail will do okay. The rest of us will either have to pay tax return preparers, or die the death of a thousand paper cuts as we slog through a swamp of calculations.
One reason why 529 Plans are getting a lot of publicity these days is that many are sold by brokers, who get commissions for making sales. Therefore, brokers promote these plans. Given the high costs and expenses, and limited investment options, of many 529 Plans, you may be just about as well off saving in low cost taxable accounts. You’d have no restrictions or penalties on how you can use the money, you have the entire world of investment options open, and you can select the lowest cost investment options available. When you withdraw the money, you won’t have the extra recordkeeping or tax return work required for withdrawals from tax advantaged education accounts.
True, the amounts stashed away in a low cost 529 Plan or Coverdell will compound nicely, being tax free, and could exceed what you accumulate in a taxable account. The amounts stashed away in a high cost 529 Plan or Coverdell may well not exceed what you could do with taxable investments, and may even be less. Either way, if the money in educational savings accounts isn’t spent on education, the exit strategies aren’t pretty and could offset the tax advantages. Taxable accounts don’t have this problem.
If you rely on taxable accounts, you would be subject to ongoing income tax liability on the gains and earnings. That reduces the compounding potential of the assets in these accounts. But depending on your choice of investments (look for tax efficient mutual funds, like index funds), the amount of taxable gains may be minimized while you’re building the account, and many of the gains and earnings may be taxed at favorable capital gains rates. Your overall returns might be quite competitive with a higher cost 529 Plan or Coverdell account.
When it comes to taxable investments, remember that U.S. Savings Bonds can be used to pay higher educational expenses with no tax on the interest if the parent(s) have incomes that do not exceed specified levels (in 2007: $65,600 for single parents and $98,400 for married couples filing jointly; with partial tax breaks for single parents making up to $80,600 and married couples filing jointly making up to $128,400). In that way, they are similar to 529 Plans or Coverdell accounts, except that there are no penalties or loss of interest for non-educational use (so there is no exit strategy problem). There is a penalty for early withdrawal of a savings bond during the first five years you hold it, but it is relatively minor (three months interest). The inflation adjusted I-Bond might be a good choice here, since you’ll have protection against inflation as well as interest income. Savings bonds can be used for your retirement without penalty if you don't use them for college expenses. Savings bonds may not produce gains as big as the stock market’s gains, but they certainly won’t generate losses, as the stock market can. You can count on Savings Bonds, since they are direct obligations of the U.S. government.
If you’re wondering why we haven’t focused on Uniform Gift to Minors Act accounts, it’s because they don’t have as much of a tax advantage as the 529 plans and Coverdell accounts, and may require more work at tax return time. They could be of potential value to relatively wealthy families, but even those families should carefully compare the value of UGMA accounts against other alternatives. A recent change in the tax code makes the earnings in the child’s accounts taxable at the parents’ bracket until the child turns 18. Previously, taxation of the child’s earnings at the parents’ bracket was imposed until the child reached 14, and after that, the child’s earnings were taxed at the child’s individual bracket. This change reduces the potential tax advantage of a UGMA account.
Social Security as a way to fund college
Social Security can help some families with college expenses. Not that it was meant to do that, but there is a little known benefit that can be used for that purpose. If you are a late-in-life parent of a dependent child (including a biological child, an adopted child or a stepchild), or a grandparent who has a dependent grandchild, your child or grandchild may also qualify to receive Social Security benefits. These are ordinary benefits, and not intended specifically for college expense. You get no tax benefit for doing so. But you can view your children’s benefits as found money and use it to build a tidy nest egg for their college expenses. Children can receive benefits until they reach the age of 18; and if they are disabled, they may be able to continue receiving benefits even after reaching 18. There are family-wide limits on how much you and your kids can receive, which can be anywhere from 150% to 180% of your benefits. For more information, go to www.ssa.gov/retire2/yourchildren.htm.
If this is an option for you, the availability of benefits for the child means that you have to carefully consider when to begin taking Social Security benefits. With only yourself in mind, you might have thought it best to delay starting benefits. If a child enters the picture, the household as a whole may be better off if you start collecting benefits at an earlier date. Check into the numbers for various start dates and figure out where you and your kid(s) are collectively best off. (You may need to speak with a Social Security employee to get a better idea of the numbers.)
How much of your income should you allocate to saving for college expenses?
This is a question only you can answer. Ideally, you should not shortchange your retirement savings in order to save for college expenses. If possible, save the percentage of your income that will give you the retirement lifestyle you desire, and then save for college expenses from the remaining income. That, however, is more easily said than done. This is a choice that you must make, and understand that you must make a choice. A financial planner may be able to help. But be wary of a planner who tells you that you can eat your cake and have it, too. If that planner claims to be able to ensure you a golden retirement and full funding for your child’s Ivy League education, the planner may actually be putting your money into high risk investments that might generate the large amount of money you need, but also could result in catastrophic losses that could wreck your retirement and make your child a scholarship student. Whatever you do, bear in mind our suggested investment guidelines and our discussion of managing investment risk.
As of 2007, federal financial aid rules treat 529 Savings Plans, 529 Prepaid Plans and Coverdell accounts created by parents as parental assets. Thus, they don't make one of these savings vehicles preferable to another. However, financial aid rules change faster than runway models change outfits at a fashion show. And many colleges use different criteria for financial need than the federal rules, when deciding how to award scholarships, grants and other assistance. That only confuses things since you don't know which college(s) your three-year old child might enroll in so you can't factor these different criteria into the saving equation. So this is one area where you might get an unpredictable and unpleasant surprise.
If your income levels allow you to take advantage of the tax benefits of using U.S. Savings Bonds for educational expenses, they would be a good choice, especially if you use the inflation adjusted I-Bonds. If you're within the prescribed income limits, savings bonds offer the tax advantages of 529 Plans and Coverdell accounts, but have no exit strategy problems. While Savings Bonds don’t offer long term returns comparable to the stock market, if your kid(s) is less than 10 years away from college, they will allow you to avoid the risk of stock market losses (which are a meaningful risk in the near term). Besides, people who qualify for the tax break for educational use of Savings Bonds won't be wealthy, and can't easily recover if the stock market swoons.
If you want something other than Savings Bonds, there is no simple analysis to figure out if you should choose a 529 savings plan, a 529 prepaid plan, a Coverdell account, taxable savings, or some combination of them. For people with incomes above the Coverdell limits, the decision is less complex—open a 529 account or save in regular taxable accounts. For everyone else, consider your needs and how much money you have to fund educational accounts.
If your child will attend private school for his or her primary education, a Coverdell account can be used to finance it. This may be one of the best uses of a Coverdell account, if your income levels are low enough to let you have one. However, a lot of the people who can afford to send their children to a private school will have incomes higher than the levels permitted for Coverdell accounts.
A tax sheltered educational savings account like a 529 or a Coverdell tends to make more sense for parents who start saving when the kids are very young, and the savings have a lot of time to compound tax free. You can come out ahead, compared to a taxable account, if you can find a 529 plan or Coverdell account with low fees and expenses. If all your options have high fees and expenses, you may well be better off saving in a taxable account, using low cost mutual funds.
Don’t forget the exit strategy problems. The money in a Coverdell account must either be spent on education or is given to your child by age 30 (after taxes and a 10% penalty). You're not entitled to get it back. The money in a 529 Plan not used for educational expenses can find its way back to you (after taxes and a 10% penalty). The money in a taxable account, of course, is yours to use any darn way you choose.
If you qualify for Social Security benefits, and have a dependent child or grandchild, apply on behalf of the child for benefits. Use the child’s benefits to build a college nest egg.
If all this 529 and Coverdell blabber and tax work gives you the mother of all headaches, just do your college savings in regular taxable accounts, using investments with low fees and expenses. You’re more likely to save if you feel you understand what’s going on and are comfortable with it. If all goes well, the only worries you’ll have when the young one marches off to academe will be whether or not he or she finds direction in life, studies enough, goes easy on the booze and partying, avoids illegal drugs, stays away from high risk personal activity . . . (okay, we’d better stop here).
Now that you're on your way to putting much of your savings toward your child's college education, let’s go next to our discussion of how you might salvage your retirement by boosting your benefits. If you just can't seem to save for retirement, read our discussion of hope for the financially lost. And don't forget to think about estate planning.