College Investing Primer
If there's college tuition in your future, you need to create an investment strategy to cover the cost. The longer you delay putting a plan into place, the greater the likelihood you'll face the prospect of having to borrow large sums or limiting your child's college choices.
They're not quite as simple as ABC, but here are some frequently suggested ways to approach investing for college. Remember, though, that investment returns are not guaranteed and your account could lose as well as gain value.
- Establish education accounts, separate from any other investment accounts. Putting money into 529 college savings plans and/or Coverdell education savings accounts (ESAs) for individual beneficiaries allows you to use tax-free withdrawals to pay qualifying expenses. You may want to use taxable accounts as well.
- Add money to your accounts in a lump sum or on a regular schedule. You may qualify for state tax deductions in some states if you're a resident who puts money in the state's 529 plan.
- Choose investments based on your children's ages. One popular approach is stressing investments with the potential for growth in the early years and those with a reputation for safety as the child gets closer to 18.
INVESTMENTS TO AVOID
There are a number of investments that don't usually work very well as ways to invest your college savings, either because they're too aggressive or not aggressive enough. Or they may be hard to cash in when you most need them. They include:
- Any investment that doesn't pay enough interest to beat the rate of inflation, including savings accounts, short-term bond funds, money market mutual funds, and similar investments
- Any investment that's not easily liquidated, such as real estate, unit investment trusts, and limited partnerships
- Any speculative investments that expose you to greater than average risk of losing principal
THE VALUE OF EQUITIES
TIMING IT RIGHT
There are some investments you can time, like the dates when your CDs and zero-coupon bonds come due. Since you'll need a cash transfusion, usually in August and January when the new semesters start, you can plan to have the money available then. Colleges usually require payment in full when students register, though you may be able to arrange a monthly payment plan to spread the cost over the academic year.
Should you put investments earmarked for college in your child's name instead of your own? There are two arguments in favor of this - that you'd be less apt to spend the money for something else, and that your child might owe less tax than you on any money the investments earned. But there are also several potential drawbacks to this practice:
- Children under 19, or 24 if they are students, pay tax at their parent's rate once they earn more than a minimum the government sets, so there is no tax advantage for children younger than this age if the investment is producing major earnings
- Once you put money in a child's name, you give up the right to use it yourself, except for the child's direct benefit. At 18, 19, 21, or 25 (depending on the type of account and the state) the child can spend it as he or she wishes
- If you are planning to apply for financial aid, a child is expected to contribute a higher percentage of his or her assets than you are of yours (approximately 20% vs. 5.65%)
Earnings in Coverdell education savings accounts (ESAs) - formerly called Education IRAs - can also be withdrawn free of federal and sometimes state income tax to pay qualifying education expenses for children in grades K-12. The only drawback is cutting into the amounts you've set aside for college.
CATCHING THE LOWER RATE
One way to take advantage of your child's potentially lower tax rate after he or she turns 19 or 24 is to make a gift of stocks or stock mutual funds to the child before they're sold to pay college or graduate school tuition. Since your child, not you, is selling the investment, the taxes on the profits will be calculated at the child's capital gains rate, which could be as low as 0%. And you won't owe any gift tax if the value of the stock or stock fund at the time of the gift is less than the tax-free annual gift amount. In 2019, that's $15,000 per recipient, or $30,000 if you're married and file a joint return.