othing puts you in the here-and-now like having a baby. Minute by minute you attend to the
feeding, diapering, and soothing that go into being a good parent. The last thing on your
mind is saving for your child's college education 18 years down the road. But it's none too
early to think about it.
"The best time to start saving for a child's education is the day he or she is born," says Elizabeth Allen, a certified financial planner (CFP) in Farmington Hills, Mich. "With the magic of compounding, you can ‘nickel and dime’ your way to savings."
By starting early, even a modest amount socked away each month can add up to a tidy sum for college or other post-secondary education. But the longer you wait, the bigger that monthly savings will have to be; eventually it mushrooms to a figure most families couldn't dream of setting aside.
But if you've saved little or nothing, and your child is already past training wheels or even asking for your car keys, are you beyond hope? Not necessarily. You still can develop a saving strategy.
Don't sacrifice building
your retirement savings
to pay for college.
|Coming up with a number |
First, you need to figure how much you’ll need. While it's difficult to pinpoint an exact number when college is years away, you can make a fair guess. Is your child likely to go to a private or public college? Tuition, fees, and on-campus room and board at a four-year state college now average $7,773 a year, according to the College Board in Reston, Va. Annual private school costs average $20,273.
But those are today's numbers. College costs usually inflate about 5% annually. At that rate, by the time today's newborn hits college, a state school may cost around $19,000 a year, a private college $49,000 a year. Those are rough averages. With a financial calculator, you can figure a more precise projection for a specific college, based on its cost today and how many years remain before your child enrolls.
"If you don't want to take your shoes off to do this calculation," advises Dennis Filangeri, a CFP in New Orleans, "the easy way to do it is to ask what it would cost to send your kid to a college today. Divide that by the number of years you have to save. Save that amount (annually), and let interest compounding and inflation take care of themselves."
Say the current four-year cost at a college of your choice is $40,000, and you have 18 years to accumulate it. You'd need to save roughly $2,200 a year. "If you start saving that amount now," Filangeri explains, "by the time the child gets to college, you should have the equivalent of what $40,000 would purchase today."
Once you have an idea of what college will cost, decide what portion you'll cover. How much do you believe your child should contribute? Are you likely to qualify for financial aid in the form of scholarships, grants, and loans?
|Save in whose name?
You can set up a college savings account in either your name or your child's. The latter type is known as a Uniform Gifts to Minors Act (UGMA) account. Putting money in an UGMA means earnings will be taxed at the child's lower tax rate.
But beware of two key disadvantages. First, that money belongs to the child upon reaching legal age. "If your child decides he or she doesn't want to use that money for college," Allen points out, "and would rather go to the Cayman Islands, there's nothing a parent can do about it."
Second, having the account in your child's name will reduce financial aid. In the financial aid formula, a child's assets weigh more than a parent's. "The worst case is where you have parents whose child is in junior high," Allen says, "and all of a sudden they start saving for college, putting it in an UGMA. They may not be able to save enough, and they'll disqualify themselves from getting aid because they have money available" in the child's account.
What investment vehicles are best to build your college fund? That depends on how long you have to let your money grow. The less time, the fewer risks you should take because you'll soon need the money to pay college bills. "If you have a long horizon, say seven years or more," Filangeri advises, "there's nothing wrong with a growth or growth-and-income mutual fund. If you have less than seven years, you might look at income or bond mutual funds. If you have only three years, consider money market or short-term bond funds."
If college is looming and you've saved nothing, financial aid may be the answer. In the meantime, put whatever you can save in your 401(k) or build equity in your home by prepaying your mortgage. "Let the compounding or growth take place there, where it won't count against you (in financial aid calculations)," Allen advises, "and then borrow out of your home equity or 401(k)" to fill in whatever financial aid doesn't provide. Remember, though: Don't sacrifice building your retirement savings to pay for college. You likely can borrow for school, but you can’t borrow to fund your retirement.
The best time
to start saving
for a child's
the day he
or she is born.
account in the
has tax benefits,
but may cost you
in lost financial aid.
Another savings vehicle is the Education IRA, which allows you to save up to $500 a year, if you fall below income limits$150,000 adjusted gross income on a joint return, $95,000 for an individual. Your contribution is not tax-deductible, but you pay no taxes on the money upon withdrawal.
Even if you were to save the full $500 a year for 18 years at a 10% return that would yield about $23,000, not nearly enough for four years of college even at today's prices. And remember, because the account is in your child's name, you'll get less financial aid.
In years you withdraw from an Education IRA, you can't take two tax credits: the Hope Credit, good for up to $1,500 each of the first two years of college, or the Lifetime Learning Credit of up to $1,000 a year. But, you can claim one of the credits by taking a distribution from an Education IRA and paying taxes on the earnings. Although the distribution won't be tax-free, you'll still benefit from the tax-deferral on the earnings. You also cannot use an Education IRA in conjunction with prepaid tuition plans.
Many states now offer the latter. In a prepaid tuition plan, you pay tuition at today's rates, and the state usually promises to cover full tuition when your child is college-ready. These are tax-deferred accounts set up in your child's name. On the plus side, these programs lock in tuition at today's prices and spare you from having to make investment decisions to build college savings. The drawbacks? The plans cover tuition only. If your child decides to go to school out-of-state, you may lose all earnings (varies by state). Plus, if you're at all investment savvy, you could do better growing your money on your own.
More flexible than prepaid tuition plans are the newer college savings plans now available in some states. These allow you to save larger amounts, tax-deferred, plus some states give tax deductions. You can use the money you save for any college anywhere.
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