While I tend to do things the hard way, finding college savings isn’t one of the areas where I complicate a task. For some reason, my sixteen year old twins helps me focus on whether a 529 plan, Roth IRA, or savings bonds will treat me right.
So, even though I’ll generally remember to add softener to the washing machine just after it’s finished, I understand how college plans operate up and down.
If you’re saving for college, it’s important to categorically work through the details of each plan to determine which best fits your needs.
…because there IS A right way to save for college, and a wrong way to save.
The bad news? The BEST way to plan college savings differs depending on who you are and what your circumstances may be.
I know that sounds generic and evasive, but it’s true: the best way to save for college will depend on your own income, current savings and college goal, so the best course of action will be this:
Know what plans exist and how they’ll affect your ability for financial aid before investing a dime.
If you haven’t yet, you should read the pieces on:
– 5 Steps to a Successful College Plan – This will guide your plan of attack when creating a college plan.
– Narrow Your College Search – This will focus your college search to those schools which are the best fit, both financially and for your particular interests.
After reading these two thorough primers, you’ll be armed with an idea of the cost and feasibility of your favorite school.
Let’s now save for the goal: education.
Complicated Ways to Save For College
Some methods of saving for college are so fraught with risk that I’m reticent to ever recommend them to people. That doesn’t mean that these college savings plans are bad; on the contrary, they all have some huge upside potential, provided that all the right conditions exist. Here are a few:
In-State Tuition Reimbursement Plans – Many states offer plans which reimburse the cost of college credits at a later date. This can be a fantastic way to lock in the price of a college, provided that everything goes according to plan.
Upside: Paying today’s rates for in-state public institutions. Don’t have to worry about market conditions or returns on investment.
Downside: Have to worry about state plan solvency. More than one state has already notified participants that they might not be able to meet their obligation. In fact, some plans no longer guarantee that your dollars will lock in present rates. Instead, these plans invest your money with state funds. Who wants their state government as a money manager?
Life Insurance – Some life insurance plans, such as whole life and universal life are presented as attractive options for education savings vehicles.
Upside: These plans are financial-aid friendly. When completing a FAFSA application, money inside of life insurance policies doesn’t count against your savings, acting as a nice shelter. Also, if for some reason the insured passes away, money is available for education.
Downside: You may have to cancel your life insurance policy to withdraw education funds. What if you still need the policy? Also, do you really need life insurance? If the answer is yes, and you’re sure that you will no longer need coverage after this incident, then this might be a good option.
Watch out for fees, too. Not only will you pay for insurance, but often a policy which offers stocks and bonds are filled to the brim with fees to manager and (maybe more importantly) to withdraw funds.
Still want life insurance in your account? Read this good article at FinAid.org for a more in-depth argument: Variable Life Insurance Policies.
Annuities – Tax deferred savings may seem like a good option for education planning. Why save into an account that’ll be taxed every year when you can shelter your money?
Upside: These accounts are FAFSA friendly, meaning that they are not usually counted in the equation for financial aid. Many annuities offer some flexible savings options.
Downside: Too many to mention here, but mostly: fees and penalties. Make sure you’re going to be over age 59 1/2 before you remove money, because if not, there’ll be IRA penalties on top of whatever the annuity company may charge.
Taxes can be a bear. Here’s why: when you withdraw cash, dollars in the account are removed in a LIFO (last in-first out) accounting manner. This means that all interest on the account must be taken before principal is removed. Why is this a big deal? Taxes. You’ll pay taxes as if you earned the money in the year you remove the money. This income may also make your chances of receiving financial aid worse in the following year.
Less Complicated But FAFSA or Tax Return Unfriendly
Stocks or Stock Based Mutual Funds – These accounts can be used whenever you wish, assuming the dollars aren’t inside of a tax shelter. In some years there’s a chance of nice returns, too.
Upside: Returns. While there are no guarantees, over long periods of time the instability of a stock or stock-based exchange-traded fund or mutual fund can be countered with a high average annual return.
Downside: Risk. There is a chance you could lose a substantial amount of principal if you don’t monitor or manage your money. Also, this type of investing isn’t FAFSA-friendly. Dollars that aren’t sheltered count directly against your chances of financial aid.
Bonds or Bond-Based Mutual Funds – More stable than stocks, these types of funds have performed attractively over the last ten years.
Upside: Returns with generally less risk than stocks above. Because bonds throw off dividends as one of the main methods of creating returns, these investments often perform more consistently than stocks.
Downside: Taxes. Bonds often throw off an attractive dividend that savers often reinvest. This money, unless it comes from a special type of bond such as a municipal bond fund, is taxable every year, slowing down your return. While there has been tax reduction with capital gains taxes, these are taxed as income, which is a much higher tax bite. These are also FAFSA unfriendly investments, unless you use government savings bonds. These can be good to you tax-wise, as long as they’re titled correctly and cashed in the same year as you’re paying qualified education expenses.
The Easy Way To Save For College
Roth IRA Plans – A Roth IRA is generally a retirement savings vehicle. Money invested gives you no tax benefit today, but can be taken tax free during your retirement years. You’ll have to follow a few rules, but you are allowed to withdraw funds for college. You may also use nearly any time of investment you choose inside of a Roth IRA.
Upside: Tax shelter. This money can grow tax deferred for education, and if you end up not using it can be used later for retirement, tax free.
Downside: Retirement savings. The best use of a Roth IRA is clearly as a retirement savings vehicle. While money can be used for college, why miss out on the main Roth opportunities around retirement?
Coverdell Education Savings Accounts (ESAs) – These plans allow you to save not only for college, but also for earlier years of private school expenses.
Downside: Funding. Man, these accounts are small. Because you can only place $2,000 per year into this type of account, they often don’t make sense. I’d also meet people with very limited funds in a few different Coverdell IRAs. Who can manage all these little accounts effectively?
The IRS page on Coverdell ESAs is very helpful. Find more details here.
529 Plans – State sponsored education plans offer a good tax shelter, are somewhat FAFSA friendly, and eliminate taxation of dollars as long as funds are used for qualified education expenses.
Upside: Amounts of savings. You can pack tons of money into these plans. Most allow as much as $300,000 to be invested into a 529 account. These accounts can either be in self-directed fund options or can be in age-based options. If you don’t use the money for the primary beneficiary, funds may be used by siblings, parents, children or other close relatives. In these plans your choice of education institutions isn’t limited to a single state. You may use these dollars in any state and still receive the tax benefit.
Downside: Money earned in a 529 plan must be used for education expenses or you’re slammed with penalties. If you aren’t sure about saving for college, funding your Roth IRA first might be a better idea, because while these funds are flexible for college funds, money will be trapped here.
Of these, the savings option I like best is a 529 plan, because of its flexibility, range of schools that accept funds, and tax treatment. While it isn’t best for everyone, for the vast majority it’s where you should save for college.
Here’s How To Evaluation 529 Plans
Just like we’ve told you previously that Morningstar is the best way to evaluate mutual funds, I like savingforcollege.com to evaluate 529 plan options.
Here’s a link to savingforcollege.com. Have a look around to see how thorough this site is on investing for education.
The Good – Lots of information on FAFSA and college savings options. Great reviews on the fees associated with 529 plan savings accounts.
The Bad – While fees are certainly important, I’m about returns. Savingforcollege.com does a poor job of comparing how money managers work unless you’re willing to fork over some money for a premium membership. When compared to more robust money management sites such as Morningstar.com, there’s no reason to pay for this information.
Can I recommend a single-best 529 plan?
Check your state’s plan options at savingforcollege.com to see how they stack up. Always evaluate a few national plans to see how they compare against your own state’s options.
My favorite national plan is UPromise, though I also like the T. Rowe Price option.
I’ll attack this next week, but here’s a preview: not only is the plan managed better than most options available, but if you sign up your credit and debit cards, but using the Upromise Rewards program (which you can sign up for whether you use a Upromise 529 plan or not) you’ll receive points which can translate into extra money into the 529 plan later. Combine the benefits of low cost investing, good management and extra money, and you’ve found a plan that’s hard to beat.
If you want to compare Upromise with your state’s plans, here’s a link for more information: Upromise is the smart way to save for college!