Guide to College Savings

college savings

Is your child hurtling toward college but you haven’t given more than a few anxious thoughts to how you’re going to pay for it?

Join the club.

For every parent who has been dutifully socking it away since the baby was in onesies, I seem to run into 10 more who feel like they’re playing an unwinnable game of catch-up. School is drawing closer, tuition projections seem to grow more outlandish by the year, and the stock market is moving sideways–and that’s on a good day.

With mortgages to pay and sneakers to buy, many families have difficulty finding the extra money to save for college. But judging from feedback from my friends and acquaintances, a time crunch has been an equally important deterrent against creating a college-savings program. The alphabet and number soup of college-savings vehicles (529s, Coverdell Education Savings Accounts, UTMA/UGMAs) seems hopelessly complex–surely more than anyone could tackle on a Saturday morning or a Wednesday night before going to bed.

True, there are many different avenues to college savings, and your own savings rate and tax bracket play a significant role in determining which route is best for your family. (For a thorough overview of the different options, check out my colleague Sue Stevens’ column.) But there are a handful of college-savings solutions that make sense for a broad swath of parents, even those who think they’re getting a late start.

Read on for a look at our best tips for getting going today.

1. Resist the urge to stand still.
I’m a lifelong procrastinator; heck, as a high-school student I was once so behind on a term paper that I had to dictate it to my sister while she typed. (As you might expect, that was the first and last time she let me get away with that.) So trust me when I say I know the sick logic that we procrastinators employ. If I haven’t done anything yet, you think, why start this minute?

But look at it this way. Thanks to compounding, a dollar saved today is much more valuable than a dollar saved 10 years from now. And even if you manage to save only a small amount between now and the time your child is ready for college, he or she is going to have to borrow that much less for tuition. The key is taking that first step.

2. Don’t play catch-up by chasing overly risky investments.
Instead of sitting still, some parents who fear they won’t be able to afford skyrocketing college costs might be tempted to do the opposite: swing for the fences in the hope of hitting it big.

But as anyone who bought an Internet stock in the late 1990s will tell you, investments that have posted big past returns often carry extreme risks. Thus, the best way to save for college isn’t to concentrate in a single risky stock or sector, but instead to build a well-diversified portfolio with a stock/bond mix that suits your child’s time horizon. Bear in mind that if your child’s college years are drawing near, you’ll want to be taking fewer risks with any money you have earmarked for college, not more. While savings for children under 10 may safely be invested in stock funds, the majority of your child’s college savings should be in cash and bonds by the time he or she hits high school.

True, bonds and cash don’t have the same return potential as stocks do. But if you’re afraid that your college savings will come up short when it comes time to matriculate, your best option is to plan to save more rather than venturing into inappropriately risky investments.

guide to cllege savings

3. Consider a 529 savings plan.
529 plans have been getting a lot of negative press lately, with critics citing high expenses, hidden fees, and substandard investment choices. But given that 529s permit extremely generous contributions and offer tax benefits to boot, these programs can be ideal for late-start college savers who need to sock away as much as possible in a short period of time. The key is to choose carefully.

Although Section 529 prepaid tuition programs essentially allow you to lock in today’s tuition rates, such plans can be somewhat inflexible. If your child wants to go to school in another state, for example, some of the tuition costs many not be covered.

In contrast to the prepaid programs, money invested in Section 529 savings plans can be used at any college in the U.S. There are no earnings restrictions on who can contribute to a 529 plan, and you can contribute up to $55,000 per year per child without triggering the gift tax. Aggressive 529 savers could, in theory, sock away enough to cover a child’s complete education. Your contributions to a 529 plan can grow tax-free, you can take tax-free withdrawals to pay for college expenses, and you may also enjoy a state-tax break. (Beware, however: Some states, including Illinois, essentially cancel out the 529’s state-tax benefits if you opt for an out-of-state plan. And while many experts expect that 529’s tax benefits will remain intact for years to come, the tax-code provision that allows federal tax-free withdrawals from 529s is set to expire in 2010 unless Congress renews it.) Finally, the 529 assets are held in the parents’ name, meaning these assets receive more favorable treatment than the child’s assets in financial-aid calculations.

Not all 529s are created equally, however. Although you may enjoy a state-tax break by sticking with your own state’s plan, high costs and poor investment returns could outweigh that benefit. Thus, it pays to shop carefully, and to look beyond your home state’s plan if it’s not up to snuff. Check out Morningstar’s 529 Plan Information Table for a snapshot of the various states’ plans. To date, our analysts have identified Utah’s plan as the gold standard of 529 plans: Not only is it the least costly 529 around, but it also carries a stellar lineup of Vanguard funds. Maryland, Virginia, and Nebraska all have standout 529 programs as well.

4. Simplify with all-in-one funds.
For college savings, I’m a fan of funds that “mature,” or grow more conservative, as the child nears college age. (The closer your child is to needing to tap into those assets, the thinking goes, the less fluctuation you want to see in your principal value.) Many 529 plans, including the topnotch Utah program, feature such one-stop, “age-based” options, and they make perfect sense for parents who would prefer to select a plan and tune out.

If the costs and complexities of 529 plans lead you to opt to save for college in your taxable account or via a Coverdell Education Savings Account (the old Education IRA), you can still find plain-vanilla mutual funds that grow more conservative as college draws closer. Most such funds are designed for people nearing retirement age, but I think they’re equally useful for college savings. Vanguard’s Target Retirement funds, Fidelity’s Freedom funds, and T. Rowe Price’s Retirement series funds are all solid, low-cost, low-maintenance options. All of these funds carry specific years in their names (e.g., Fidelity Freedom 2020 FFFDX); simply choose the fund with the year that corresponds with your child’s college start date.

5. Cheap out.
If your investment horizon is relatively short, it’s all the more important to pay attention to how much you’re shelling out in fund fees. That’s because cash and bonds–which should form the bulk of your child’s portfolio as college draws near–have low returns to begin with. If you layer on excessive expenses, your take-home return will be that much lower. For your college-savings plan, focus on stock funds that charge less (preferably much less) than 1% per year in annual operating expenses; look for bond funds with expense ratios of 0.75% or lower.

For similar reasons, late-start college savers will want to be careful about how much they’re shelling out in brokerage charges and other administrative fees. Morningstar’s 529 Plan Information Table includes details on 529 fees and other administrative expenses associated with each state’s plan.

6. Accentuate the positive.
Even if you haven’t established a dedicated college-savings fund, you may be able to tap valuable assets right under your nose. After a decades-long runup in real estate prices, for example, many homeowners are sitting on fat home-equity balances that you can draw upon to pay for education expenses; you’re also likely to enjoy a tax break on the interest from the home-equity loan.

Similarly, parents might also consider tapping their own IRAs to pay for college. Depending on the type of IRA, you’ll pay taxes on part or all of the withdrawal, but you won’t pay the usual 10% early withdrawal penalty if you use the money to pay for qualified education expenses. If you engage in such a maneuver, however, bear in mind the costs to your own retirement savings plan. Loans and financial aid may be available to your college-bound child, but you’ll have fewer options available if your own retirement-savings plan falls short.