If there’s college tuition in your future, you need to create an investment strategy to cover the cost. The longer you delay putting a plan into place, the greater the likelihood you’ll face the prospect borrowing large sums or limiting your child’s college choices.
AN INVESTMENT PRIMER
They’re not quite as simple as ABC, but here are some practical ways to approach investing for college. Remember, though, that investment returns are not guaranteed and your account could lose as well as gain value.
- Establish education accounts, separate from any other investment accounts. Putting money into 529 college savings plans and/or Coverdell education savings accounts (ESAs) for individual beneficiaries allows you to use tax-free withdrawals to pay qualifying expenses. You may want to use taxable investment accounts as well.
- Add money to your accounts in a lump sum or on a regular schedule. You may qualify for state tax deductions in some states if you’re a resident who puts money in the state’s 529 plan.
- Choose investments based on your children’s ages. One popular approach is stressing investments with the potential for growth in the early years and those with a reputation for safety as a child gets closer to 18.
When your children are young, it makes sense to invest primarily in equities, such as stocks and stock mutual funds or exchange-traded funds (ETFs). If you reinvest all the earnings or use them to make similar investments, the value of your portfolio has the potential to grow over time. One advantage of a 529 savings plan or an ESA is that the reinvestment happens automatically.
As they get older you may want to begin switching some of your portfolio into generally more price-stable investments, including equity income funds and intermediate-term Treasury bonds. If stock prices increase sharply, you might also sell some of your investments to protect your gains. But you still may want to invest for some growth. In a 529 savings plan, an age-based account makes this transition, although at a different pace than you might choose. If you chose a fixed track concentrated in equities when your child was young, you might add a fixed track of fixed-income investments during this period and make your new contributions to this track.
As your child gets closer to college and actually enrolls, you may want to include more income-producing investments, and continue to transfer part of your equity assets gradually into more conservative investments. The schedule should be dictated by when your tuition bills come due, not by what you think the market’s going to do. But, if the stock market goes way up at any point in this period, you may want to take advantage of selling when the prices are high. In other words, you may want to speed up — even if just a bit — the shift from stocks and funds to less volatile investments.
INVESTMENTS TO AVOID
There are a number of investments that don’t usually work very well for college savings, either because they’re too aggressive or not aggressive enough. Or they may be hard to cash in when you most need them. They include:
- Any investment that doesn’t pay enough interest to beat the rate of inflation, including savings accounts, short-term bond funds, money market mutual funds, and similar investments
- Any investments that carry surrender fees that would apply in the period when you’ll need to liquidate
- Any investment that’s not easily liquidated, such as real estate, some unit investment trusts, and limited partnerships
- Any speculative investments that expose you to greater-than-average risk of losing principal
THE VALUE OF EQUITIES
Investments that have the potential to grow in value — stock, exchange-traded funds, and mutual funds in particular — are appropriate choices for meeting expenses that are constantly increasing. You can get all the advantages of long-term equity investing by starting a college fund when each child is born.
With a tax-deferred plan like a 529 savings account or an ESA, no taxes are due on investment earnings while they accumulate and withdrawals for qualified expenses are tax free. When you’re using a taxable account, you can minimize taxes by making investments you intend to hold in your portfolio for a number of years to postpone capital gains. Qualifying dividends are taxed at your long-term capital gains rate.
The risk of equity investing, though, is that growth is not guaranteed. Your account could lose value in a market downturn or if individual investments didn’t meet your expectations. That’s a risk you have to be willing to take to have the potential for growth.
TIMING IT RIGHT
There are some investments you can time, like the dates your CDs and zero-coupon bonds come due. Since you’ll need cash transfusions, usually in August and January when the new semesters start, you can plan to have the money available then. Colleges usually require payment in full when students register for a new term, though you may be able to arrange a monthly payment plan to spread the cost over the academic year.
When you’re buying zero-coupon bonds, it’s especially important to buy those that mature during the four- or five-year period that you’ll need the cash. If you have to sell them before they’re due, you may take a real beating on the price as they tend to be volatile in the secondary market. If you’re buying US Series EE or Series I Savings Bonds to pay college expenses, remember that you have to keep them at least five years to collect the full interest you’re due.
As an added bonus, if your income is less than the amount established by Congress for the year in which you withdraw, interest on those savings bonds is tax free if you use them to pay qualifying college costs and meet certain ownership requirements. You can check the website of the Department of Education (www.ed.gov) or the savings bonds website (www.savingsbonds.gov) for more information.
THE NAME ON THE ACCOUNT
Should you put investments earmarked for college in a UGMA or UTMA account in your child’s name instead of your own? There are two arguments in favor of these types of accounts — that you’d be less apt to spend the money for something else, and that your child might eventually owe less tax than you would on any capital gains or dividends the investments produce. But there are also several potential drawbacks to this practice:
- Full-time students younger than 24 pay tax at their parent’s rate once they have more in investment earnings than a minimum the government sets. So there is no tax advantage for children up to this age if the investment is producing major earnings
- Once you put money in a child’s name, you give up the right to use it yourself, except for the child’s direct benefit. At usually 18, 21, or 25 (depending on the type of account and the state) the child can spend it as he or she wishes
- If you are planning to apply for financial aid, a child is expected to contribute a higher percentage of his or her assets than you are as a parent (approximately 20% vs. 5.65%)
CHECK IT OUT
Earnings in Coverdell education savings accounts (ESAs) can be withdrawn free of federal and sometimes state income tax to pay qualifying education expenses for children in grades K-12. The only drawback is cutting into the amounts you’ve set aside for college.