If you have decided to save for your child's college education, you are already ahead of the game. Now the question is, where you should invest that money?
Ideally, you want your stash to be safe, available when you need it, and growing as quickly as possible in the meantime.
Time is Money
The more time you have before your child starts college, the better stocks look. Historically, stocks have returned more than bonds, and although they carry more risk year to year, the added risk disappears over periods of 10 years or more. Stock returns have averaged about 11 percent -- nearly twice those of bonds -- since 1926. And they have gained in every 10-year period, including the decade of the Great Depression.
That means if you have at least 10 years before your child enters college, most financial planners suggest you invest the bulk of your college savings in stocks. You can select individual stocks or choose mutual funds that own growth and value stocks. Look for funds run by a reputable company, and try to contribute at regular intervals -- even if you can only manage $50 a month.
By the time your child enters high school and your time horizon shrinks to less than five years, you can start to move a large part of the money into volatility-proof investments such as CDs, money market funds or U.S. treasury bonds.
Tax-Advantaged Savings Plans
Congress has enacted several tax breaks to encourage families to increase college savings. Tax-free or tax-deferred investments raise your ultimate returns without raising risk levels. Here are the pros and cons of your savings choices.
State-Sponsored College Savings (529) Plans
- Advantages: Tax-deferred asset growth. Contributions allowed up to about $100,000 a year. Some states allow residents to deduct contributions from state taxes. When withdrawn to pay for higher education, gains are taxed at the lower child's rate (some states levy no state taxes on gains).
- Disadvantage: Investment strategy is decided by plan administrators, not by you. Investments may not be aggressive enough for risk-tolerant investors who think they can earn more than enough to balance the tax advantage.
- Advantages: Money can grow and be withdrawn tax-free as long as it is used for higher education.
- Disadvantages: You can contribute only $500 per year, and education IRAs cannot be used in conjunction with other tax-free plans such as the state-sponsored 529s. Most important, money from all IRAs can now be withdrawn without penalty when used to pay for higher education. Because you can contribute up to $2,000 a year to other IRAs, your money may add up faster that way.
Prepaid Tuition Plans
- Advantages: Pay current tuition rates for an education far in the future. No worrying about investment returns.
- Disadvantages: Full tuition is only covered if your child decides to go to an in-state college. Prepaid plans replace financial aid, so they may not be a good deal for a child who will qualify for substantial aid. If your child decides on a private college -- or none at all -- the plan will pay according to how much your investments have earned.
This is not a tax-advantaged college savings plan in the strict sense, but it can be a neat trick. Grandparents with money to spare can pay tuition bills directly to a college without incurring a gift tax. Funds owned by grandparents do not show up on the family financial aid application, so this is one legitimate way to "hide" assets.