College savings plans
Dear Dr. Don,
My kids are an infant and 3 years of
age. What is the best way to save for their college? I currently
have a savings account for my 3 year old, but I feel that I could
You can do better.
Increases in college tuition routinely outstrip increase
in inflation. A savings account will struggle to keep pace with
inflation and isn't a very attractive investment vehicle for your
children's college fund.
Think about more than just setting money aside. Think
about how the investment returns are taxed, how investment returns
have to outpace rising costs to see an increase in your purchasing
power, the annual expenses of investing in different plans and how
different plans will influence your child's ability to qualify for
The big four in college savings are: prepaid tuition
plans, college savings plans, Coverdell Education Savings Accounts
and Savings Bonds for Education.
Section 529 Qualified Savings Plans include prepaid
tuition plans and college savings plans. Prepaid tuition plans can
guarantee that your investment will cover tuition costs at schools
covered by the plan. These plans are typically offered by states
with the state guaranteeing tuition money equivalent to the cost
of its state schools' tuition. The portability of the tuition money
to other schools will vary by program.
Prepaid tuition plans are forced savings in that you
have to either deposit enough today to cover the plan cost or arrange
a time payment plan. Either way, you're contracting to put enough
aside to cover the plan's cost.
In contrast, college savings plans are investment
vehicles that don't guarantee that the student will have enough
in the account to cover tuition expenses. Distributions out of the
account are free of federal income taxation and usually free of
state income taxes too.
The difference between the two types of qualified
savings plans is similar to the difference between a "defined
benefits" and "defined contribution" plans for retirement
savings. The prepaid tuition plan has a defined benefit while the
college savings plan has defined contributions but its success in
meeting your child's college expenses is based on the plan's investment
does a great job rating the various Section 529 plans and providing
an overview of tax, gift and account control issues for these plans.
Coverdell Education Savings Accounts (CESA's) are
what used to be called Education IRA's. You invest with after-tax
dollars but qualified distributions are free of federal taxation.
Contribution limits were increased to $2,000 per beneficiary in
the 2002 tax year. You have a lot more flexibility in how you invest
in these accounts. You can open an account with a bank, a brokerage
firm or directly with a mutual fund family. Keep an eye on the account's
annual expenses since high fees and expenses can really create a
drag on the account's returns.
For smaller amounts I like the Savings
Bonds for Education approach. The bonds are registered in the
parent's name but the income is tax-free when used for qualified
college expenses. This keeps the money available to the parents
for financial emergencies. There are some income restrictions on
who is eligible to use this plan so it's not right for everyone,
but that's true for CESA's too.
So much depends
on your personal finances, if and where your children
decide to go to college and your state's income
tax code that I can't give you a definitive answer
about which plan to choose. Investing in your children's
future, however, will always be a winning proposition.
If you look at your options and end up not being
able to decide, then consult a tax professional
to help you make a decision.