The best time to start saving for college — for your children, grandchildren, nieces, nephews, or other family and friends — is as soon as they’re born. But if you didn’t get off to a quick start, don’t despair. You can start now by choosing among a number of different investment plans that not only provide the opportunity for your savings to compound tax deferred but also offer the possibility of tax-free withdrawals for qualified expenses when the student enrolls.
In fact, you may decide that you prefer to diversify your college investing and use several of these approaches in combination. Some have annual contribution caps while others allow you to be more generous if you can afford to be.
The college savings plans known as 529 plans are sponsored by individual states and managed by financial institutions, such as brokerage firms, insurance companies, and mutual fund companies. When you set up a 529 account, you designate a beneficiary for whom you’ll use the money to pay qualified higher education expenses, including the cost of technical or trade school, college, or graduate school. The beneficiary can usually be anyone, including yourself.
Since most states offers at least one 529 savings plan, you have the flexibility to choose a plan that best meets the criteria you set. In fact, you can open more than one 529 plan for the same beneficiary if you choose, if you want to take advantage of the varying strengths of more than one plan. In most cases neither you nor the beneficiary has to live in the sponsoring state to participate in its plan.
There are no age limits that restrict when a beneficiary must use the money. And, if you wish, you have the right to change the beneficiary to another member of the same extended family.
Among the things you’ll want to consider in choosing a 529 plan are:
- The plan’s investment options and historical returns
- The fees, expenses, and state tax treatment
- Beneficiary rules
- Contribution limits
You may want to begin your search by investigating the plan sponsored by the state where you live, as many states offer extra incentives to residents enrolling in their plan. Your withdrawals may be free of state as well as federal income tax, for example. Or you may be entitled to deduct a portion of your contribution on your state tax return. But you may lose those advantages by choosing another state’s plan. For more information on the provisions of specific plans, you can check www.collegesavings.org, a website sponsored by the College Savings Plan Network.
Remember, though, that as with any investment account, returns on 529 savings plans are not guaranteed, and you could lose money, especially in the short term.
ON THE RIGHT TRACK
Most 529 college savings plans offer either age-based or fixed tracks, or both. An age-based track allocates your investment across different asset classes based on the beneficiary’s age when you open the account, and then reallocates to create a more conservative portfolio as the child gets closer to college age.
With a fixed track, you choose whether to invest in equities, fixed income, balanced, or stable value funds. The portfolio’s exposure to risk doesn’t change over time, and the results are based on how the underlying investments perform.
You can change the way your account is invested once a year without changing beneficiaries, and you can always choose a different alternative for new money you add to the plan. You can also move money from one state’s plan to another once a year. In addition, you can change the way your account is invested whenever you change beneficiaries, which can be helpful, for example, if the new beneficiary is much younger than the former one and you want to put more emphasis on equities.
You may also consider a prepaid tuition plan, which is another type of 529 plan. With a prepaid plan, you pay for future college costs by buying tuition credits at today’s rates. The catch is, some of these plans don’t guarantee that the amounts you prepay will cover the full cost of the credits you’ve purchased when your child enrolls.
Most of the plans are sponsored by individual states, and the credits usually apply to public institutions in the state. Other states allow access to all participating colleges and universities in the state, both public and private. There’s also a Private College 529 Prepaid Plan, sponsored by more than 270 private colleges and universities, including some of the most highly regarded institutions in the country. Credits you purchase through the Private College plan are guaranteed, and they can be used at any participating school.
However, participating in a prepaid plan does not guarantee your child will be admitted to one of the schools where the credits apply. And if he or she enrolls elsewhere, the refund you get may reflect only minimal earnings or no earnings at all.
COVERDELL EDUCATION SAVINGS ACCOUNTS
Like 529 plans, Coverdell education savings accounts (ESAs) offer tax-deferred growth and tax-free withdrawals when you use the money to pay for qualified education expenses. With ESAs, that includes expenses incurred in grades K through 12, as well as vocational training, college, and graduate school.
With an ESA, you choose the investments for your account, which gives you more control over how your money is allocated than you have with 529 plans. There are limitations, though. Instead of investment ceilings that can be $300,000 or higher, as they are for some 529 plans, annual ESA contributions per beneficiary are capped at $2,000. There are income limits governing who can contribute to an ESA. The beneficiary must be younger than 18 when the account is opened, and must use the money before turning 30, although you can change beneficiaries to another member of the same extended family.
US SAVINGS BONDS
When you redeem certain Series EE or Series I US savings bonds to pay for qualified education expenses, you may qualify for a tax break. However, for the bonds to be eligible, they must be purchased individually or jointly by people older than 24 at the date of issue and used to pay tuition for an owner, his or her spouse, or a dependent.
There’s another small catch to the tax break for education expenses on US savings bonds: Your adjusted gross income must be less than the limit set by Congress in the year you withdraw to qualify for the tax-free benefit. Of course, there’s no way to predict what that amount will be when you are ready to use the money. But you’re free to hold on to the bonds if you don’t qualify, or you can cash them and pay the tax that’s due. In that case, you can spend the money for the student’s nonqualifying expenses if you wish and use your 529 or ESA money for qualifying costs.
EVALUATE YOUR ALTERNATIVES
- Compare the investment alternatives of different college investment plans, and narrow the list to those that are best for you. You may decide to use a combination of plans.
- Evaluate 529 college savings plans to find the ones with the most attractive investment alternatives at the lowest cost. You may want to start by investigating your home state’s plan.
- Combine making contributions to a 529 plan with putting money into some other college saving opportunities, such as a prepaid plan, ESA or savings bonds, to diversify your investments.
- Don’t plan on raiding your retirement plan to pay for college expenses — your beneficiary could receive grants or scholarships, but you alone are responsible for your retirement.