How Do You Save For College?
I have recently started to explore the intimidating prospects of saving for college. I want to be prepared to send my kid(s) to a good college. For now, let's assume I intend to have only one kid. I will not have more unless I can afford them. Like every parent, I hope to see my kid go to some good college. It'll be nice if he/she wants to be a doctor and go to Harvard but I don't expect him/she to. But it's important to be well prepared. So I'm assuming a worst / best (depends on your perspective) case scenario here (i.e. my kid turns out to be a genius and wants to go to Stanford).
I'm in my mid-twenties, married with no kids. I'm hoping to get a head start. However, after perusing some websites, I'm still undecided. Using this calculator, with the following parameters:
Tuition: $40,000
Years of College: 4
Years Until College: 18
College Savings: $0
Estimated Rate of Return on Investment: 7%
Estimated Inflation: 3%
Federal Tax Rate: 30%
State Tax Rate: 8%
I need to save $880/month to accumulate $287,362. But, if I were to wait say another five years before I have a kid, I only need to save $707/month for 23 years. So, the moral here is to start early. With $40,000 today, theoretically one could attend Harvard and still have clothes on one's back. I think 7% ROI is conservative.
Anywho, now that I know how much I need for my imaginary kid's college it's time to find out where to stash the cash. Here's how much I know about some of the vehicles available for college savings.
There are three common tax-advantaged ways to save for college:
Coverdell ESA
Joint filers with less than $220k can contribute with an annual limit of $2000. I can invest however I wish. Earnings are tax-free if used for qualified expenses. However, assets are considered to belong to the student which will affect the chances of getting financial aid. But then, I'm assuming a worst case scenario where my kid is not getting financial aid. Still, the kid gets full control of the account at age 18. Hmm... not very good.
529 Prepaid Tuition
Basically, I'll be paying tuition at today's rate. In return the state will pay for my kid's tuition later. Nevertheless, nothing is guaranteed. And, naturally, I have to pay a premium for this. I have full control of the assets. However, plan administrator invests my money. Not very comforting. Also, how will I know which college my kid wants to go to?
529 College Savings
Contribution limit is fairly high depending on state — between 100k to 305k. Again, assets are managed professionally. Currently, earnings are tax-free until 2010. Beyond that no one knows.
The problem I have with the 529 plans is the assets are professionally managed. In my college cost estimate, I'm assuming a 7% return. What if the professionals earn less than 7% return? Of course, investing on my own doesn't guarantee a 7% return either. But, at least I can blame myself and maybe do something about it. At this point, Coverdell ESA looks appealing. But Coverdell only allows an annual contribution of $2000. And, the phase-out is pro-rated according to your adjusted gross income. So if my joint income is halfway between $190k and $220k, I can only contribute $1000/year. That is clearly not enough!
The other option I could think of is just invest in common stocks outside of the tax-advantaged methods. Obviously, I'll be missing out on the tax advantages which can mean a very big difference in the end. Should I be using all methods? How do you save for your kids' college?
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The Coverdell assets do not belong to the child and can be transfered to another child at any time.
We're saving more in our Roth IRAs to help with future education funding, in addition to the Coverdell contributions.
I haven't found a 529 with low expenses and good returns.
With regards to matt's comment. Coverdell accounts are considered the childs asset with regards to qualifying for financial aid.
With regards to your planning fatboy, personally I dont think you should be worried about it until you have a child. But if you must start saving, then why not a ROTH IRA, if you qualify. This way if you never have a child or the child doesnt go to college then you have more in retirement for yourself. If you fund a ROTH IRA starting now with $4,000 a year, any distributions made for "qualified education expenses" will be tax free to you if you have met the 5-year holding period (ie have had the underlying assets being withdrawn in the account for 5 years). In addition, any contributions you put in to the ROTH will be able to be withdrawn without paying any taxes if for "qualified education expenses". This gives you twice the savings that a Coverdell allows and also makes it possible to receive the money at retirement without any possible penalty if the Coverdell is liquidated for "non-qualifying expenses".
Just a clarification: Coverdell accounts are NOT considered the child's asset with regards to qualifying for financial aid.
If the account owner is the parent, Coverdell is NO LONGER considered as child's asset since 2004.
1) You've assumed 3% inflation. College tuition is going up about 7-8% per year. Should one assume 7 or 8% inflation instead?
2) 529 College Savings: Vanguard has low fees. One can't buy individual stocks, but one can invest in their funds.
My fourth son in now enrolled at a top liberal arts college. Tuition, fees, and room & board for the 2005-06 academic year total $44,420. Can't find the 1995-96 charges for a 10-year comparison, but for 1996-97 at this same college, the comparable t,f,r&b charge was $27,460. This reflects a 4.93% compound annual increase in costs over the past 9 years. So.....might be a good idea to assume $45,000 in annual tuition costs today, and a 5% annual increase over the applicable time horizon.
It should be borne in mind that colleges typically expect parents to pay around 5.0 to 5.5% of their annual pre-tax income and another 5% of their assets toward tuition each year; however, 40% of any assets held in the student's name will be considered available as a tuition source each year, along with perhaps the first $2,000 Junior earned over the summer. Thus, there is a strong disincentive to put assets in the student's name. Instead, it may be preferable from a financial aid perspective to mentally earmark certain parental accounts as being "Junior's college fund" but keep these funds in the parents' names. This assumes, of course, that the parents have a reasonable expectation that meaningful need-based financial aid (meaning grants and scholarships, not loans) may come Junior's way.
Parents who scrimp and save are penalized in the awarding of financial aid, whereas those who took that around-the-world cruise and bought that big three-masted schooner (colleges don't ask what kind of boat you own....unless you're dumb enough to list the boat loan as a liability on your fin'l aid application) make out bigtime.
Incidentally, make sure Junior studies hard for the PSAT (taken in his Junior year of high school). Sure, it's just a practice test for the "real" SAT...but...it's the PSAT, not the SAT, that's used in determining who gets a National Merit Scholarship. And be sure that, if he qualifies, Junior gets considered for other scholarships like the Robert C. Byrd Honors scholarship ($1,500/year renewable for 4 years). Some colleges (like Emory in Atlanta) give top students free tuition PLUS an annual stipend. Elmira College offers free tuition to Valedictorians. Univ. of Buffalo offers free tuition to Nat'l Merit finalists. Several states have tuition-free programs for top in-state students attending state schools.
Also, if your child can get into a service academy (think not only West Point/Annapolis/AF Academy, but also Coast Guard and the US Merchant Marine Academy), tuition is free (that is, paid by us taxpayers). [Check out the pay and lifestyle of USMMA grads--you won't believe it!--how come nobody told me when I was 18???]
Oh....as for spacing kids out, you are much better off from a financial aid award standpoint to have twins, triplets or quadruplets. Or at least kids just one or two years apart. Colleges will be more inclined to give you a break in such circumstances. But as for getting any breaks if you have one undergrad and one (or two) in grad school at the same time, fuggetaboutit.
