The Money Question: Saving for Your Child's College Education
Q. I know I need to start setting aside money for my kids' college educations, but I'm not sure how. What exactly are 529 plans? Are they all they're hyped up to be?
A. Are you sitting down? Here are the shocking numbers: A child going to college this fall can expect to pay, on average, $75,000 for four years of -in-state public school, $130,000 for out-of-state public, or $150,000 for a private school. Worse, if education inflation continues at its historic rate -- it has far outpaced overall inflation for decades -- those costs will double for a child entering college a decade from now.
Clearly, any money you set aside while your kids are young will help defray what you have to beg, borrow, steal -- and pay interest on -- later. Still, make sure you're fully on track for retirement (meaning you're making the necessary contributions to your 401(k) or IRA to meet your retirement goals) before you set money aside for college. There are no retirement loans, but it's relatively easy to borrow for education.
What Is a 529 Plan?
Named for the Internal Revenue Code that Congress established in 1996, this college savings program works much like a Roth IRA, allowing you to invest after-tax dollars in mutual funds. Then, when you withdraw money for qualified education expenses (including tuition, room and board, and textbooks), you don't pay any federal taxes on the return your investments have earned.
Is a 529 the best way to save?
In a word, yes -- primarily since these plans grow tax-free and are compatible with any post-secondary school, including trade school. Three other key advantages: (1) The funds are treated as your assets when financial aid and student loan eligibility are calculated, which is more favorable than having it in your child's name. (2) It can be transferred from one child to another -- even to a grandchild or yourself -- in the event that the intended recipient doesn't go to college or gets a full scholarship. (3) The contribution limits are high: You and your spouse can each put up to $14,000 a year in each child's account. And grandparents can contribute an additional $14,000 each. In fact, all of you could (perhaps for estate-planning purposes) condense five years of contributions into a single year without owing any gift tax. In other words, each parent and grandparent could give a child $70,000 in a single year and then $0 for the next four without incurring a tax hit (normally 35 percent for any amount over $14,000).
What plan do I choose?
Start with your state's plan because many states offer additional financial benefits for residents. In 34 states, contributions are deductible off that year's state income taxes or investment growth is state-tax-free at the time of withdrawal, or both. And while some states require a holding period of a few years, others allow you to funnel money through a 529 account for just a few days and still take a tax deduction. Check your state's plan website for details as well as other benefits. For example, some states fully exempt their own 529 funds from financial-aid calculations for schools (public or private) that are in that state.
If your state offers any benefits like this, look no further. If it doesn't, shop around. Reject any fund with an expense ratio of more than .75 percent. And choose a plan that is sold directly to the customer, without an adviser as middleman, and is run by a brand-name company such as Vanguard, Fidelity, or TIAA-CREF. You can check vital stats on each state's 529 plan at savingforcollege.com.
Which Investments Are Best?
Most 529 plans offer a small menu of mutual funds, much like a 401(k). I recommend picking an age-based allocation. These programs start out with an aggressive, stock-heavy portfolio when a child is an infant and gradually move to a more conservative, bond-centered mix as the child nears college age. This means you don't have to actively manage your investment options and it moderates the risk that a market downturn right before your child starts college could demolish your savings. Set up an automatic monthly contribution to each child's plan, add every monetary gift that your child receives -- and, if you want, let the whole thing run on autopilot.
Alexa von Tobel is the founder of LearnVest, a financial-planning website that offers articles and tools, including one-on-one planning from a certified financial planner.