The main vehicles used in saving for your children's college education are explained here: 529 college savings plans, offered by individual states, prepaid college tuition plans, Coverdell education savings accounts, Roth IRA accounts, brokerage accounts, and U.S. savings bonds.
Parents face many choices in how to save for their children's college education. The following are some of the main investment options.
529 College Savings Plans
Nebraska’s Nest 529 Plan says 57% of Americans don’t know what a 529 college savings plan is. Yet these plans are the foundational way to invest for college.
529s are offered by every state except Wyoming. You contribute to a portfolio of mutual funds. You choose from several alternatives based on your risk tolerance or the age of your child. If you choose an age-based portfolio, it’ll work like a target retirement fund, getting increasingly conservative as your child nears college age. It’s designed to transition investments to be safe enough that money will be available when college looms, without danger of a major market dip.
For most people, a prudent strategy is the right strategy. But if parents can pay from income or other resources, another specific portfolio might be chosen — perhaps one that has a static balance or emphasizes stocks.
Although 529 plans have higher costs than a simple portfolio of mutual funds bought directly, they allow investments to grow tax-free (but no federal income tax deduction for contributing). As long as the money is withdrawn for educational expenses (including K-12, college, and graduate school), there’s no tax on withdrawals.
Thirty-four states offer deductions for contributions to the state-sponsored plan if you're a resident. But Arizona, Kansas, Minnesota, Missouri, Montana, and Pennsylvania allow you to contribute to any state’s plan and still receive the deduction as a resident.
It's also possible to invest in an “advisor-sold” 529 college savings plan. These will carry higher fees and you might pay a commission to purchase investments. If you have significant assets being managed by an investment adviser, you might want your 529 plan investments incorporated in your overall investment strategy. But it’s hard to see that many people would need so much assistance that they couldn’t make the choice from their state or another state’s plan at far lower cost.
Scrutinize your state plan’s selections. You should be looking for no-load mutual funds with low management costs. If your state offers only high cost or obscure funds in their portfolios, choose another state’s plan. The tax benefits usually aren’t huge. For example, Illinois allows you to deduct up to a $10,000 contribution per year, but at Illinois income tax rates, that only saves you $500. Morningstar regularly rates the best 529 plans. Although my own state never ranks in the top, it offers a good choice of portfolios invested in no-load fund mixes.
Choices in College Savings Plans goes into more depth about these and other plans.
Prepaid College Tuition Plans
These generated a lot of interest when they were first rolled out more than 20 years ago. You invest a specific amount of money when your child is very young and are guaranteed your investment will cover tuition and fees at state schools (often pegged as the flagship state university) for a specific amount of time: by the quarter, semester, year, or four years. If the student ultimately attends an out-of-state or private school, the value of the plan (as determined by the plan) usually can be applied to other schools.
Only 11 states currently offer these plans. Before investing in these plans, which resemble deferred annuities, do some research to determine the solvency of the state. If the state is not setting aside the money but instead collecting the money using funding from general revenues, it may not have the money to meet obligations.
These plans promise to provide tuition, but room and board, supplies, and so on are significant components of the total cost of attendance, so choosing a prepaid plan will definitely not take care of everything.
In general, you must be a resident of one of the states that still offer the plans and have money available when and if they have a limited open enrollment period. A private-college prepaid plan also exists, but of course the student must be accepted into one of the colleges to use it.
Although prepaid college tuition plans do give some degree of certainty, as with all "sure-thing" investments, the actual return on your money is likely to be less than the same amount invested for 18 years in a high-quality, diversified plan. These plans most appropriate if there is a compelling need to lock up the money — such as in a divorce or inheritance. The parent cannot access or withdraw the money as in a regular 529 plan.
Coverdell Education Savings Accounts
These accounts were once popular as a way to put aside money for private school, usually high school, before 529 plans were allowed to be tapped. These work much like Roth IRAs: You make a nondeductible contribution, it grows tax-free, and you can withdraw it tax-free.
The main problem is that these accounts have a low yearly limit ($2,000 per child) and the parents must have a modified adjusted gross income under $95,000 (single) and $190,000 (married filing jointly) to contribute the full amount. Over $110,000 (single) and $220,000 (married filing jointly) you can’t contribute.
Because the potential account is relatively small, not all investment houses offer these accounts. The $2,000 may be a good goal for people who are having difficulty saving at all.
Roth IRA Accounts
If you’re eligible for a Roth, consider it before contributing to a 529 plan. Your contributions to the Roth can be withdrawn tax-free, and penalty-free if used for higher education. The earnings can remain in the account (but taxed if withdrawn). While it’s usually best to leave a Roth until retirement, if you’re not sure if you want to restrict savings to education-only use, a Roth may be a good choice for some savings that might be used for college costs.
You can’t invest in individual stocks in 529 plans but can in Roths and Coverdells. If, however, you want to invest more than those accounts allow, there’s nothing wrong with a plain old brokerage account. What you gain in flexibility, however, comes at the cost of tax shelter.
The advantage is that you have much more flexibility with how you use the funds from brokerage accounts. To learn more about identifying stocks with good long-term investment potential, sample BetterInvesting's free tools, education, and resources.
U.S. Savings Bonds
Series EE or I bonds purchased after 1989 are tax-free at redemption if used for qualified educational expenses. Returns on these bonds aren’t exciting, but if they’re lying around or you’ve been given them as gifts, it’s a good use to employ them in paying for education. They can also be purchased with your tax return.
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Danielle Schultz, CFP, is a fee-only financial planner and principal of Haven Financial Solutionsin Evanston, Illinois.