| Tackle College Cost (Without a Football Scholarship) |
| I recently attended a family celebration centered around the First Grandchild on that side of the tree. Instead of being besieged for stock tips (a cocktail-party hazard when you work for Morningstar), I was instead asked about the best way to save for college. |
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| But some of my relatives dismissed the issue: The child is still in the bassinet, hasn't even started kindergarten. When you can invest in a $70-pair of darling three-inch running shoes, why worry about college now? |
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| Compounding. Suppose your child is approaching the age of college entrance exams and college financial planning. On her first birthday, August 1, 1984, her generous grandparents gifted her $10,000 under the Uniform Gifts for Minors Act (UGMA), which you immediately invested in Vanguard 500 Index VFINX. With $132,748 in hand 15 years later, she only needs to get into the college of her choice. If you had invested $10,000 five years later, in 1989, it'd be worth only $48,992 today. Even delaying only one year would have cost you more than $30,000. |
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| If you don't have $10,000 to start with, or if your child just turned 10 and you haven't given her college account more than an occasional anxious thought, these examples may discourage you. Don't let them--you have all the more reason to get started. You could, for example, pick a low-minimum fund (check out the excellent TIAA-CREF or T. Rowe Price offerings), and start dollar-cost averaging. |
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| The question is how to best shelter college savings. As you may have heard, 1997 legislation created an Education IRA and also made savings in IRAs and Roth IRAs accessible for college costs. All are reasonable options, but they have limits. A mere $500 a year per child can be sheltered in an Education IRA. You may withdraw money for college costs from a regular IRA without incurring a penalty, but such withdrawals will be taxed at your income tax rate, and eat into your retirement savings. Or you can withdraw your Roth IRA contributions to cover higher-education costs, but not any gains you've earned. |
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| Gifting the child money in her own name may seem like the best alternative. Part of any annual investment income would be tax-free, and part taxable at the child's (likely lower) rate; only annual income over $1,400 is taxed at your rate and all capital gains are taxed at the child's rate. Choose a tax-efficient fund and further reduce the bite. One downside to this strategy is that such gifts can hinder a child's chance of receiving financial aid, because any money in the child's name weighs heavily in the calculations. |
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| Worse, the child gains legal control of the money at the age of majority--and she doesn't have to spend it on college tuition. Imagine your 18-year-old on a brand new Harley, wind in her hair (that is, no helmet), zipping down the road to parts unknown. |
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| Now consider 529 plans instead. Morningstar guest columnist Frank Armstrong recently extolled these plans as "wonderfully flexible," and indeed they are. The name refers to Section 529 of the tax code, which grants tax-deferred status and estate tax advantages to states' college savings plans. You can gift a child up to $10,000 a year via one of these plans and reduce your taxable estate by that amount. Investment earnings grow tax-free and are taxed at the child's rate when she uses the funds for higher-education expenses. Yet you get to keep control of the money, though it must be used for higher education: If the child opts out of school after the senior prom, you can transfer the account to one of her siblings (or another college-bound relative for that matter). A deal like that is about as good as it gets. |
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| There is a hitch: You don't get a say in how the money is invested; the state that runs your plan makes those decisions. But that's a small deterrent, considering that you can choose a state plan regardless of where you and the beneficiary live or where the child plans to attend school. (You may be eligible for state tax breaks if you invest with your home state.) You may want to avoid states with pre-paid tuition plans; if the child opts for a school in another state, you will get your contributions back, but you may not get any return on your investment. |
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| Select a state that has a tax-deferred savings plan instead of a pre-paid tuition plan. The Delaware Plan, for example, is managed by Fidelity and shifts asset allocation from aggressive to conservative as the child nears college age, much like a life-cycle fund. The College Savings Plan Network will guide you through the various states' offerings so that you can choose a plan with an investment strategy that appeals to you. You may even decide to divide your gift among more than one state plan. |
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| Of course, as simple as 529 plans can make saving for college, saving money while raising children isn't always easy. Remember, you can always pass this information on to a proud grandparent--or a doting aunt. {I've decided to go with New York's plan for my new nephew. I live in Illinois, which offers a pre-paid tuition plan, while New York has an investment plan managed by TIAA-CREF; I'm setting it up through my father, a N.Y. resident, so that he can enjoy the state tax deduction.} |
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