Thinking about how to finance your child’s college education can be daunting. Steadily increasing tuition costs coupled with interest rates that are at all-time lows creates a bleak outlook for many working class parents hoping to afford college tuition for their children. The good news, however, is that with a little research and some prudent planning, saving for your child’s educational future is easier than you might think. One of the best ways to make sure that you can afford sending your child to the college of their choice is to open a college savings account.
While simple saving accounts and brokerage accounts are both plausible vehicles for investment, there are several special investment vehicles specifically tailored for investment in college education. Let’s look at two of the most popular vehicles.
529 College Savings Plans
A 529 college savings plan is an investment vehicle operated by a state or educational institution which allows you to set aside money to pay for your child’s future college costs. Money placed into the 529 savings account is used to invest in mutual funds and other investments. Like a 401k, you can make periodic contributions to the account.
Over time, the earnings from these investments will grow into what should be a significant amount of money to use towards the costs of your child’s college education. Similar to a 401k, 529 college savings plans allow you to choose the types of investments for the account. Remember that riskier investments can lead to investment losses. Therefore, it is important to make sure that your investments are diversified across different risk categories. Make sure to have a broad mix of stocks, bonds and mutual funds in your portfolio.
It is also important to decrease your investment risk over time. This is because you will not be able to easily recover from investment losses that occur right before your child starts college. Many 529 savings plans allow you to choose an investment strategy which starts out aggressive when your child is young and becomes more conservative as your child nears college age.
The major benefit of a 529 college savings plan is that the investment earnings are not taxed as long as they are used to pay for college tuition, room and board, or other college related expenses. Keep in mind that the contributions to the account are often taxable.
Additionally, unlike 529 prepaid plans, the money in your 529 savings account can be used towards paying the expenses of any college or university nationwide.
The major drawback of the 529 savings plan is that you have no safeguard against losing money on your investments. Therefore, if you select high risk investments, you can potentially lose money and reduce your savings progress.
How to Enroll
Since almost every state has at least one 529 college savings plan, you need to decide which plan you want to enroll in. Note that you do not need to live in the state to choose that state’s plan. Because the plans vary by state, it is advisable to compare the plans to see which one best meets your financial goals. Some state plans offer different tax advantages than others. There are two ways to enroll in a plan. The first is directly with the plan administrator. The second way is through a financial adviser.
529 Prepaid Tuition Plans
A 529 prepaid tuition plan allows you to lock in all or part of the cost of future college tuition at today’s price. Prepaid plans allow you to purchase all or part of the future tuition costs at current day prices. For example, you can purchase half a year’s tuition at a state college and the prepaid plan will guarantee that your investment will pay for half a year’s tuition.
There are two types of prepaid plans:
- The first is the prepaid unit plan which sells units that represent a fixed percentage of a year’s college tuition. One unit is typically worth 1-percent of one year’s tuition. You can buy as many units as you want each year, but you should keep in mind that the price of each unit typically increases each year.
- The second prepaid plan is the contracts plan. Under this plan, you can buy a contract which promises that you will pay for a specified number of years of tuition. The price of the contract depends on the age of your child and your selected payment schedule. Contracts are typically cheaper for younger children and when paid in one lump sum.
The major benefit of the 529 prepaid tuition plan is that it allows you to pay today’s prices for future college tuition costs. Usually, the state that administers the plan will guarantee that you will receive the agreed upon cost of tuition. Since the costs of tuition have steadily risen over time, the prepaid plan can save you a significant amount of money.
Prepaid plans are exempt from federal income tax and are often exempt from state and local taxes as well. Some state’s offer full or partial tax deductions for contributions made to the plan.
The drawback of the prepaid plan is its lack of flexibility. Prepaid plans can generally only be used for public universities and colleges within the state that the plan is opened in. While some plans allow you to use the funds towards private or out of state institutions, they can penalize you for doing this. Additionally, prepaid plans typically only cover the costs of tuition and cannot be used toward room and board and other college expenses.
How to Enroll
Unlike a 529 savings plan, not every state offers a prepaid plan. Additionally, in most cases, you can only enroll in your own state’s plan. You can enroll in a prepaid plan directly through the state that offers it or through an investment adviser.