The earlier you start planning for college, the easier it can be to pay those tuition bills.
The best time to start saving for college — for your children, nieces, nephews, or other family and friends — is as soon as they're born. But if you didn't get off to a quick start, don't despair. You can start now by choosing among a number of different investment plans that not only provide the opportunity for your savings to compound tax deferred but offer the possibility of tax-free withdrawals for qualified expenses when the student enrolls.
In fact, some of these plans weren't introduced until 1995, and their tax-free withdrawal provisions weren't added until 2002. Other plans have been adapted over the years to increase contribution amounts, make them accessible to more people, or expand the way the money can be used.
The college savings plans known as 529 plans are among the newer ways to invest for college. These plans are sponsored by individual states and managed by financial institutions, such as brokerage firms, insurance companies, and mutual fund companies.
When you set up an account, you designate a beneficiary for whom you'll use the money to pay qualified higher education expenses, including the cost of technical or trade school, college, or graduate school. The beneficiary can usually be anyone, including yourself.
Since every state offers at least one 529 plan, you have the flexibility to choose the one that best meets the criteria you set. In fact, you can open more than one 529 plan for the same beneficiary if you choose, since in most cases neither you nor the beneficiary have to live in the sponsoring state to participate in its plan.
Among the things you'll want to consider in choosing a 529 plan are:
The investment options and their historical returns
The fees, expenses, and state tax treatment of different plans
You may want to begin your search by investigating the plan sponsored by the state where you live, as many states offer extra incentives to residents enrolling in their plan. Your withdrawals may be free of state as well as federal income tax, for example. Or you may be entitled to deduct your contribution on your state tax return. But you may lose those advantages by choosing another state's plan. For more information on the provisions of specific plans, you can check www.collegesavings.org, a website sponsored by the College Savings Plan Network.
Remember, though, that as with any uninsured investment, returns on 529 savings accounts are not guaranteed and you could lose money, especially in the short term.
You may also consider a prepaid tuition plan, another type of 529 plan. With a prepaid plan, you pay for future college costs by buying tuition credits at today's rates. The catch is, some of these plans don't guarantee that your prepayment will cover the full cost when your child enrolls.
Most of the plans are sponsored by individual states, and the credits apply to public institutions in the state. There's also a Private College Plan, sponsored by more than 270 private colleges and universities. Credits you purchase through the Independent plan are guaranteed, and they can be used at any participating school.
ON THE RIGHT TRACK
Most 529 college savings plans offer either age-based or fixed tracks, or both. An age-based track allocates your investment across different asset classes based on the beneficiary's age when you open the account, and then reallocates to create a more conservative portfolio as the child gets closer to college age.
With a fixed track, you choose whether to invest in equities, fixed income, balanced, or stable value funds. The portfolio's exposure to risk doesn't change over time, and the results are based on how the underlying investments perform.
COVERDELL EDUCATION SAVINGS ACCOUNTS
Like 529 plans, Coverdell education savings accounts (ESAs) offer tax-deferred growth and tax-free withdrawals when you use the money to pay for qualified education expenses. With ESAs, that includes expenses incurred in grades K through 12, as well as college and graduate school.
With an ESA, you choose the investments for your account, which gives you more control over how your money is allocated than you have with most 529 plans. There are limitations, though. Instead of investment ceilings that can be $300,000 or higher as they are for some 529 plans, annual ESA contributions per beneficiary are capped at $2,000. There are income limits governing who can contribute to an ESA. And the beneficiary must be younger than 18 when the account is opened, and must use the money before turning 30, although you can change beneficiaries to another member of the same family.
US SAVINGS BONDS
When you redeem certain Series EE or Series I US savings bonds to pay for qualified education expenses, you may qualify for a tax break. Series I bonds are sold at face value and indexed for inflation. Older EE bonds earn interest at 90% of the market yield on five-year Treasurys. EE bonds issued after May 2005 earn a fixed rate of interest and are guaranteed to double in value in 20 years.
There's a small catch to the tax break for education expenses on US savings bonds: Your adjusted gross income must be less than the limit set by Congress in the year you withdraw to qualify for the tax-free benefit. Of course, there's no way to predict what that amount will be when you are ready to use the money. But you're free to hold on to the bonds if you don't qualify or cash them in and pay the tax that's due. In that case, you can spend the money for nonqualifying expenses if you wish, without penalty.
EVALUATE YOUR ALTERNATIVES
Compare the investment alternatives of different college investment plans, and narrow the list to those that are best for you. You may decide to use a combination of plans.
Evaluate 529 college savings plans to find the ones with the most attractive investment alternatives at the lowest cost. You may want to start by investigating your home state's plan.
Combine making contributions to a 529 plan with putting money into some other college saving opportunities such as an ESA or savings bonds, to diversify your investments.
Don't plan on raiding your retirement plan to pay for college expenses — your beneficiary could receive grants or scholarships, but you alone are responsible for your retirement.