Saving for College: Three Things to Do Before Your Child Turns Five

3. Start Saving

The Smart Saver's Rule is to accumulate money in the most efficient place and then pull it out in the most efficient way. Usually this means taking advantage of tax breaks that will help your money grow more quickly. Your 401(k) plan at work is a great place to save, but chances are you'll need every penny of that for your own retirement. A terrific runner-up is the Roth IRA.

If you and your spouse make less than $150,000 and you file joint tax returns you can each fund a $2,000 Roth IRA each year. You don't get a tax break when you invest, but you can pull out your $2,000 contributions whenever you wish, tax-free. If you use the earnings for college costs, you pay regular taxes but no penalty. If you're older than 59 1/2 when your child is in college, you can pull out the earnings tax-free as well. Plus, Roth IRAs are not currently counted for figuring financial aid under the federal rules. If you save $4,000 a year and earn 9% per year, you'll have $56,000 tax free in 14 years plus $48,000 in earnings (about $32,000 after taxes).

 

When you invest in a Roth IRA, you choose where your money goes. Shop for a growth-oriented no-load stock mutual fund. The Vanguard Total Stock Market Index will spread your investment over the whole U.S. stock market. The minimum investment is $1,000 for an IRA. The T. Rowe Price family of mutual funds will let you get started in a Roth IRA for as little as $50 a month if you have the money taken out of your bank account. The Equity Index fund is a great choice.

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