Every parent has read the story of Goldilocks and the Three Bears to a toddler drifting off to sleep. This article tells a modern-day story about three college savings plans for parents of young children: those who anticipate needing lots of financial aid, those who anticipate needing some aid, and those who expect to cover all the costs of college. This story can be a bear as well. To understand each option better, let's separate fable from fact and examine each scenario.
Need Lots of Financial Aid?
If you think you'll rely heavily on financial aid for college, be sure that whatever you're saving for college goes into an account in your name, so it's regarded as a parental asset.
In determining the Expected Family Contribution (EFC) toward college costs, federal financial aid formulas count 35 percent of a child's assets, but only up to 5.65 percent of parental assets. (Private-aid formulas are complicated, but the same ideas apply).
When your child is young, you've got room to be more aggressive, so growth stocks should make up most of your portfolio. Later you'll shift to a more conservative mix, including money market funds and short-term bonds.
Need Some Financial Aid?
If you anticipate needing some aid but plan to cover at least half of tuition yourself, the above advice still applies. You should consider investing in a 529 savings plan. Contributions to these plans are tax deductible in many states, and withdrawals are free of federal tax.
The 529 account itself is treated as an asset of whoever opened the account (not the student) and unlike college-savings accounts, contributions to a 529 plan don't reduce federal aid eligibility. For more information on these plans, check out 529 Plans: The Basics.
No Financial Aid Required?
If you think you'll foot the bill for college by yourself or suspect that a very high income will disqualify you from aid, you'll want to maximize investment flexibility and tax advantages. However, don't just assume that you're not eligible for financial aid.
Custodial accounts like Uniform Gifts to Minors Act/Uniform Transfer to Minors Act (UGMA/UTMA) accounts offer a way to transfer money to a minor that holds tax advantages. They earn up to $750 tax free every year, and some or all of the additional earnings are taxed at the child's rate. If you meet the income requirements, consider putting $2,000 a year into a Coverdell Education Savings Account (ESA). Withdrawals from an ESA are tax free and can be used for precollege education expenses such as tuition at a private high school. The bulk of your savings can go into a 529 savings plan. These plans have no income limitations and allow lifetime contributions from $100,000 to $270,000, according to your state's 529 statutes.