It's hard to picture your pipsqueak all grown up and graduating from high school while he’s still a bundle in your belly, but with tuition skyrocketing twice as fast as inflation, the time to start saving for college is now (yes, on top of all the pregnancy costs and baby expenses).
Sending your little Einstein to a public in-state university in, say, 19 years is projected to cost more than $240,000 for four years; for private college, you’ll need about half-a-million smackers.
The good news: Time is on your side (hey, baby-to-be hasn't even started preschool yet), and most families don’t pay the whole bill themselves. If you're planning for a family, here’s the lowdown on the best tools to save for college — and grow your money:
529 Plan
These plans are like state-sponsored piggy banks with extras: Your money's invested and your earnings aren’t taxed.
Pros
- They’re hands off. A state agency invests your money in mutual funds and the like. Sign up for automatic deposits and you can practically forget about it.
- You avoid the tax man. As long as you spend the money on such specific college-related expenses as tuition, fees and course materials, you don’t have to pay Uncle Sam on the earnings. Bonus: Your state may also give you a tax break.
- The sky’s the limit (almost). There are some limits to how much you can contribute each year before paying a gift tax.
- You can switch beneficiaries. If your firstborn opts out of the college route, a younger sib can be the recipient without penalty.
- It has little impact on financial aid. A 529 plan is considered your asset, not your child’s, which will help your scholar get more grant money.
Cons
- The funds must go toward qualified educational expenses. If not, you pay a 10 percent penalty, plus taxes on the earnings.
- You have limited control. For the most part, someone else manages your money, and typically, you can make changes only twice a year. Plus, if the stock market takes a nosedive, your saving-for-college funds may too.
- There may be enrollment and annual maintenance fees. All this simplicity comes at a cost. Compare the charges of different plans at savingforcollege.com.
Coverdell Education Savings Account (ESA)
You can make tax-free withdrawals from these accounts to pay for college, cut costs during your little learner's school years or cover other qualified education expenses.
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Pros
- Again, you avoid the tax man. When your little one goes to pull the money out in 18 years to pay for college, she won't pay any taxes on it.
- You call the shots. Invest your money any way you want and make changes as often as you like.
- You can use the money for costs besides college. The cash can pay for elementary and/or high-school tuition, after-school programs, textbooks and even tutoring.
- It has little impact on financial aid. As with a 529, a Coverdell is counted as the parent’s asset, so your child will be eligible for more grant money.
- You can switch beneficiaries. You can switch the recipient without penalty as long as it’s a family member under the age of 30.
Cons
- You can put in only $2,000 per child per year. Two grand a year won’t get you too far in saving for college, so you need other types of savings too.
- Not everyone can get in on it. If your annual “modified adjusted gross income” (shown on your tax return) is more than $110,000 (for an individual) or $220,000 (if you file a joint return), you’re out of luck.
- There are time limits. You can contribute only until your child is 18, and the money must be used by the time he’s 30 or the remaining amount will be taxed.
Custodial Accounts
The only difference between these accounts and a regular savings account? These are in your child’s name.
Pros
- They’re easy. You control these accounts until your child hits adulthood (18 to 25, depending on your state). Set one up at any bank, contribute as much as you want, and take out money anytime to spend on anything as long as it’s being used on your child.
- They have some tax advantages. A portion of the initial investment income isn’t taxed at all.
Cons
- They can hurt your chances for financial aid. Because they’re counted as student assets, your child will get less money from the financial-aid office.
- Your child gets all the power at age 18 to 25. You can’t stop him from spending the money on a cherry-red Ferrari. And you can’t switch beneficiaries.
- They’re taxable. You’ll pay Uncle Sam every year (after that initial tax-free investment income).
U.S. Treasury Bonds
If you’re concerned about stock market ups and downs, government savings bonds make saving for college a less risky proposition.
Pros
- They’re ultra-safe. Series EE and Series I savings bonds are backed by the U.S. government and immune to stock market drops (unlike 529s).
- They’re cheap. Get one for as little as $25 and buy direct from the government at TreasuryDirect with no broker fees.
- They have some tax advantages. The interest earned is generally exempt from state and local income taxes, and if you use the money for tuition, you can get out of paying federal taxes if you’re under income limits.
Cons
- They may not keep up with tuition. No matter how high your interest rate, there’s a chance college costs will rise faster.
- You have to wait at least 12 months to redeem them. You’ll pay a penalty if you need the money back right away.
- If you have paper bonds, you can't lose them. When the bonds mature, you have to remember where you put them so you can redeem them.
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