How to pay for college: The 18-year plan

For contemporary parents, the main problem is that the cost of a college education is growing faster than the economy. When my kids are in college, for example, around 2029, analysts estimate public tuition will cost roughly $44,000 annually.

Here’s the good news: “You have time on your side,” says Chad Ernzen, senior vice-president of investments for the Mutual Fund Store in Westminster.

As soon as you have a Social Security number for your child, you can start saving. Ernzen advises clients to “start with whatever amount is available, and increase as you go."

A family that sets aside $50 a month starting when their child is born will accrue more than $21,000 in an account that earns 7 percent interest per year by the time college rolls around. When you’re ready to start contributing, you’ll need to settle on the right plan – and that can be confusing. Here’s our rundown on the most popular college savings vehicle (a 529 Savings Plan), plus two other devices suitable for stashing collegiate cash.

529 Plans

“I can’t think of a better way to structure an account,” says Jeff Nelligan, senior vice president and financial adviser with Morgan Stanley in Denver.

He’s referring to 529s, often called CollegeInvest plans in Colorado, and investors concur: 188,321 Colorado account owners have saved $3.4 billion. 529 Plans give more bang for the buck by allowing account owners – typically parents or grandparents – to invest money into future higher education expenses without being taxed on the earnings.

The first step is finding the right plan. This isn’t like a 401(k), which is a national plan. Forty-nine states (all but Wyoming) and the District of Columbia offer 529 Plans that vary dramatically by state. In Colorado, you’ll buy your 529 Plan through an agency called CollegeInvest, or through an investment firm. Because there’s no residency requirement, you don’t have to stick with Colorado’s plan if another state’s serves you better. Some families even buy plans in multiple states.  

But, says Betty Lochner, past chair of the College Savings Plan Network (CSPN), “We always recommend investors start with their state’s plan because a lot of times there’s an incentive to do that.”

Colorado’s state tax deduction, for example, can be persuading: Contributors may deduct the full amount of their contributions from their Colorado adjusted gross income. Colorado also has a dollar-to-dollar grant-matching program for low- to mid-income families, and a 529 Scholarship for those feeling the middle class squeeze.

“We have one of the most diverse plans in the nation,” says Angela Baier, CEO for CollegeInvest. Colorado investors actually have four options for funding their account. Each plan has the same tax benefit — the difference is in how you like to save.

“We have one of the very few FDIC-insured programs in the nation,” Baier says, noting the Smart Choice plan lets investors save at a bank.

For those who are nervous about investing in the stock market, Stable Value Plus is an annuity program with guaranteed principal and an annual guaranteed return; the plan’s return is so good, in fact, it routinely draws out-of-state investors. Colorado’s most popular 529 Plan is Direct Portfolio. Offered through Vanguard, this program lets you invest in stocks, bonds and cash. For those who want their account actively managed by a financial adviser, there’s Scholars Choice — ranked No. 1 in the country for performance.

The latter plans have age-based investment options, designed to correlate risk tolerance with the beneficiary’s age.

“As with any investments,” says Lochner, “investors in 529 Plans should look carefully for the investment option best matching their risk tolerance, investment objective and the age of the child.”

Funding Your Account

Baier advises parents to open the account in their name – either spouse, it doesn’t matter – and list the child as the beneficiary.

When you’re looking to build an investment over time, it’s all about being disciplined, and making regular contributions. Nelligan advises clients treat 529s like a 401(k), contributing a small amount from each paycheck. People save three times more when they set up direct deposit from their paycheck, adds Baier.

Once you’ve opened the 529 Plan, anybody can contribute at any time. Grandparents, especially, like the idea of contributing to something big – and they’re attracted by the fact that the account purchaser is the only one who can request deductions, which means young adults benefiting from the plan can’t use the money frivolously. Grandparents will also get a tax deduction because it’s the contributor – not the account holder – who deducts the contribution during tax season.

Making Withdrawals

When it’s time for college, qualified withdrawals are tax-exempt, and this includes expenses associated with books, required school supplies, on- or off-campus housing and, of course, tuition. You can even use 529 funds to purchase a computer. And, if a beneficiary receives a scholarship or gets a full-ride, you can take out the amount of the scholarship, tax-free. All accredited, post-high school certificate and degree programs are qualified. Here’s Baier’s cheat sheet: “If you can get a federal student loan from the school, you can use your 529 dollars there.” This includes traditional four-year colleges – public and private – along with community colleges, graduate school, trade and vocational schools — possibly even yoga teacher certification, if it’s done through an umbrella of an accredited school.

It doesn’t matter where you open your plan — you can use the money at any qualified institution in the country, plus a host of eligible schools abroad. If 529 dollars are used for non-qualified expenses, they’ll be subject to federal and state taxation, at a 10 percent penalty rate on earnings, explains Ernzen, adding, “Before you pay the penalty, transfer to other relatives.”

If an intended beneficiary doesn’t drain the account, the remainder can be transferred, tax-free, all the way out to first cousins. That means a beneficiary’s parents, siblings, step-siblings, cousins or spouse can take advantage of the money without paying taxes on investment income. And, there’s no age limit imposed on a beneficiary. Thanks to recent legislation, if a college student has to drop out, 529 withdrawals can be re-deposited into the account without penalty.

Other Ways to Save

With 529 Plans, says Ernzen, “There’s some flexibility, and yet there’s not.” Maybe you’re an aggressive investor, or maybe you want to help your child with multiple aspects of young adult life. CollegeInvest Plans might be the most popular, but they aren’t your only option.

Education Savings Accounts can be established for any child under 18, and can help parents save for both college and K-12 tuition costs. Investors who aren’t limited by their AGI can deposit up to $2,000 per year until a beneficiary turns 18. With 529, you’ll recall that investment options are limited; with Education Savings Accounts, though, your investment choices are broad. Earnings accumulate tax-free, but you won’t have to wait until college to make withdrawals; this vehicle can be used for qualified K-12 education expenses, too. The investor controls the account until a beneficiary reaches the age of majority, and funds are available until that beneficiary turns 30.

If you want your child to have options regarding how they use their savings, consider a Custodial Account. Anybody can open one because there’s no limit on AGI. There aren’t any contribution limits, either — but don’t forget to consider gifting laws when funding the account. Annual earnings are typically taxed at the account owner’s rate. The money in the account, though, belongs to the child, and any funds used before the child reaches the age of majority must be used for his or her benefit, which covers anything from orthodontia to a college education. Keep in mind that once a beneficiary reaches the age of majority, you’re legally obligated to hand over the reigns to the account.

Parents and guardians can also grow cash in accounts held in their names. “The downfall,” says Ernzen, “is that it does take discipline.” There’s no tax benefit here, and you’ll pay capital gains taxes on the investment. The benefits are broader investment options and complete control. Account holders choose when – and if – their child gets the cash. If a child doesn’t need the money, parents can funnel it into their retirement.