From a financial standpoint, being the parents of college-bound children is no picnic. College can be costly if you don't plan ahead and stay focused. While the price of a four-year college education is certainly attainable, you have to take steps to ensure that it stays that way. These days, it takes more than just saving—you've got to save smart. Here are some of the best ways to tackle the puzzling process of saving for college.
Education Savings Accounts (ESAs)
One popular choice for parents today is the Coverdell Education Savings Account, formerly known as an Education IRA. For families in higher tax brackets, ESAs can be attractive since the 2001 Tax Relief Act raised the maximum annual contribution from $500 to $2,000 per child. (It also raised the income eligibility limit for married couples opening an account to $220,000 a year).
Pros: ESA contributions are not tax deductible, but they do grow tax free. You may invest your contributions any way you'd like, but withdrawals must be used for qualified educational expenses, the definition of which has been broadened to include elementary and secondary school tuition, along with ancillary expenses such as tutoring and computers.
Cons: The downside to ESAs is that these funds are considered student assets under federal financial aid formulas. Since families are expected to kick in 35 percent of the student's assets (versus up to 5.65 percent of parents' assets) more student assets usually translates to less aid received.
529 Savings Plans
Thanks to the Tax Relief Act of 2001, 529 savings plans offer some of the biggest tax breaks around. As long as it's spent for higher education, money in these accounts grows free of federal tax, and in many states, contributions are tax deductible. You can learn more about these plans by reading 529 Plans: The Basics.
Pros: These plans are an excellent choice for high-income families who don't qualify for ESAs. There are no income limits, contributions can go as high as $11,000 annually before triggering the gift tax, and lifetime contribution limits are as much as $270,000 in some states. Middle-income families may also benefit from the tax-free compounding. Also in the 529 family are prepaid tuition plans, which allow parents to lock in current tuition prices for future degrees. Most are sponsored by individual states for use at public institutions, but increasingly they let you convert these prepaid dollars into tuition at private and out-of-state schools. As with other 529 plans, earnings in prepaid accounts are tax free (and tax deductible in many states).
Cons: These plans tend to offer limited investment options. Most are age-based funds, shifting to a conservative mix of stocks and bonds as your child ages. It's often tricky to change investment tracks, since high fees may be assessed when you sell or buy a fund. There are also tax consequences and penalty fees for funds not spent on higher education. Further, current federal laws specify that assets in 529 prepaid tuition accounts are considered to be a student resource, counted dollar-for-dollar in reducing federal financial aid eligibility.
Custodial Accounts (UTMA/UGMA Accounts)
Custodial accounts, known as Uniform Transfers to Minors Act (UTMA) accounts or Uniform Gifts to Minors Act (UGMA) accounts, can be used by families who expect to pay for college themselves or who suspect their high income means they won't receive financial aid.
Pros: UTMA/UGMA accounts offer investment flexibility and up to $750 a year in tax-free earnings.
Cons: Since they're considered an income-producing student asset, these accounts may cost more in aid eligibility than you may save in taxes. Another drawback is a lack of parental controls. Your child takes over the account upon reaching eighteen, and since UTMA and UGMA funds are not restricted to educational uses, you'll have no recourse if your child uses the money for something else.
The Earlier the Better
No matter which of these family-friendly investment options you choose (or even if you choose a blend of all three), you'll get the most bang for your college-investment buck by starting early, thanks to compound interest. After all, time is the best tool for creating wealth.