Smart Ways to Save for College

He makes a good salary but has no job security. She’s currently a stay-at-home mom. The older of their two girls heads off to college in five years. If the kids attend their parents’ alma maters, Princeton and Columbia, the family will likely need about $600,000 to cover tuition, fees, and room and board.

No worries. Michelle and Barack Obama got off to a good start on the college bills a few years ago, when they contributed a hefty sum to a 529 savings plan. These state-sponsored investment plans are among an array of programs, some with tax benefits, that help families (including the First Family) save for one of the biggest expenses of their lives.

Tuition hikes have exceeded in­flation over the past several decades, bringing private-college costs to an average of $36,993 and in-state costs at public colleges to $16,140 in 2010–11, according to the College Board. If your children are, say, 13 and 10 (as are Malia and Sasha Obama), expect a combined sticker price of more than $200,000 in in-state costs. Parents of an infant and a toddler face a combined cost of about $360,000.

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Notice the words sticker price. Most families get a discount off that price in the form of grants, scholarships and education tax breaks; more than two-thirds of students also take out loans to help cover college costs. Rather than aim for the entire amount, figure on coming up with about a third in savings and using current income, grants and loans for the rest. (To calculate costs, go to www.finaid.org/calculators and click on “College Cost Projector.”) Whatever the game plan, “starting early is the key,” says Deborah Fox, of Fox College Funding: “You’re always going to be much better off doing something than nothing.”

529 savings plans

Sponsored by 50 states and the District of Columbia, 529 plans let your savings grow tax-free, and the earnings escape tax completely if the withdrawals are used for qualified college expenses, including tuition, fees, and room and board. The appeal of 529 plans lies in their easy access as well as their tax benefits. The plans set no income limit and a high limit on contributions. Two-thirds of the states and the District of Columbia give a tax deduction or other tax break for contributions. If your kid skips college, you can change the designation to a sibling without losing the tax break. Cash out for non-college purposes and you’ll owe income tax and a 10% penalty on earnings (but not on contributions), and you may have to return any state tax deductions.

Most states offer two types of college-savings plans: a low-cost plan sold directly by the state and a higher-cost plan sold by a broker. Buy a 529 directly from your state if the plan offers credits or deductions on your state income tax return. The lower expenses of a direct-sold plan mean that more of your money will go toward building your college fund, and the state tax break will trump lower fees in an out-of-state program.

If your state doesn’t offer a tax break -- or if you live in Arizona, Kansas, Maine, Missouri or Pennsylvania, which give a tax break no matter where you invest -- consider stashing your college savings in one of the following plans. For low fees, try the Utah Educational Savings Plan, which supplies a broad menu of Vanguard index funds. Alaska’s T. Rowe Price College Savings plan has a mix of high-performing portfolios made up of actively managed funds. The Michigan Education Savings Program, run by TIAA-CREF, has plenty of conservative options for people who want to stay out of the stock market. The College Savings Plan of Nebraska offers the widest selection of fund options among direct-sold plans, including funds from Fidelity, Pimco and Vanguard. And if you feel more comfortable using an adviser, Virginia’s CollegeAmerica is a top-notch choice among adviser-sold plans. (See a state-by-state guide to our 529 picks.)

Most states offer age-based port­folios, which adjust the mix of in­vestments automatically. But some age-based plans are more aggressive than others, says Joseph Hurley, of Savingforcollege.com. If you can’t afford to lose a penny, “go with the plan that gets you completely out of stocks as the kids get close to college,” he says.

One drawback of 529 plans: “You don’t have direct control,” says Rick Darvis, a CPA and college financial planner in Plentywood, Mont. After you pick a portfolio, you must wait 12 months before you can change the mix or transfer the money to another plan. And a state-appointed firm manages the account, not you.

Prepaid plans

Planning to send your kid to school in-state? Sign up for a state prepaid tuition plan. These plans, most of which are available only to state residents, let you lock in tuition at public colleges in your state years in advance. They offer the same tax benefits as 529 savings plans, and you pay the same tax and penalty if you don’t use the money for qualified expenses. Currently, 21 states offer the plans, of which nine are closed to new enrollment. (About 270 private colleges let you prepay through the Private College 529 Plan.)

States use different methods for carving tuition and fees into sellable chunks, but they all require that you buy several years before your child starts college and charge you somewhat more than the current year’s tuition. If your student goes to an out-of-state or private school, you can transfer the value of the account or get a refund, but the amount won’t necessarily cover the cost of the school.

Coverdells

Coverdell education savings accounts are similar to 529s in that the money in the accounts grows tax-deferred and escapes tax if you use it for qualified education expenses. Coverdells expand the definition of “qualified,” however, to include tuition at private elementary schools and high schools. If you withdraw the money for nonqualified expenses, you pay tax and a 10% penalty on earnings.

You can set up a Coverdell at a bank or brokerage firm and tweak the investments as often as you like, but the total amount you contribute per child cannot exceed $2,000 a year, and the beneficiary has to be under age 18. To contribute, you must have a modified adjusted gross income of less than $110,000 as a single filer and $220,000 as a married couple filing jointly. The provisions on Cover­dells will become less generous in 2013 unless Congress extends the terms.

Roth IRAs

As a last-minute strategy for paying for college, raiding a Roth IRA is a loser. “Most parents are not fully funded for retirement,” says Fox. “If they make withdrawals to pay for college, there’s no way to get those amounts back.” But if you start early enough, the Roth’s tax-favored status and flexibility can help you hit both goals.

You can contribute up to $5,000 annually ($6,000 if you’re 50 or older -- but you’re starting early, remember?). The money grows tax-free, and you avoid tax on withdrawals that don’t exceed your contributions. You also avoid a 10% early-withdrawal penalty on earnings if you use the money for educational expenses. If both you and your spouse save the max over 18 years, you’ll accumulate $180,000 in contributions alone. With earnings of 8% a year, the total tops $400,000 -- enough to carve out a slice for college and still have a decent retirement fund.

You’ll owe tax on any earnings you withdraw unless you are 59½ and have held the account for at least five years. In 2011, the ability to contribute to a Roth IRA disappears at a modified adjusted gross income of $179,000 for married couples filing jointly and $122,000 for single filers, giving you another reason to start young, while your income is relatively low.

Custodial accounts

With custodial accounts, known as UGMAs (for the Uniform Gifts to Minors Act) and UTMAs (for the Uniform Transfers to Minors Act), you put money or other assets in trust for a minor child and, as trustee, manage the account until the child reaches 18 or 21, depending on your state. At that age, the child owns the account and can use the money for whatever he or she wants.

Full-time students under age 24 pay no tax on the first $950 of unearned income and the child’s rate on the next $950. Earnings above $1,900 are taxed at the parents’ marginal rate. That’s no big deal, says Fox: “Unless you’re putting in really large amounts, the money is not going to generate over $1,900 a year.” And the accounts offer a refreshing freedom. “You don’t have to designate funds for college and are not restricted to the investment choices in the plan.”

An option to avoid: life insurance

You’ve heard the pitch. With a cash-value life insurance policy, you can save for college and improve your chances for financial aid while covering your family in the event of your death. Some policies let you choose among an array of investments, the better to supercharge your savings. Others keep your money in fixed-income investments that protect against inflation. In all cases, earnings grow tax-deferred. You can withdraw up to the amount you paid in premiums tax-free, or take out a policy loan.

As tempting as the strategy may sound, don’t fall for it. “The problem with life insurance policies is that the sales charges are high, and the return on investment is low,” says Mark Kantrowitz, of Finaid.org. It may take you as long as ten years to contribute enough to overcome the expenses and another ten to build enough cash to make a dent in the college bills. If you withdraw money within the first seven to ten years, you could also be subject to a surrender charge. With variable policies, if the investments do poorly, you could end up with less than you put in and a lower death benefit than you need.

As for the idea that stashing money in a life insurance policy improves your chances for financial aid, that’s only true to a point. The federal financial-aid formula ignores the cash value in life insurance policies in calculating the assets it expects families to contribute to college—but income, not assets, is “the key driver” in the calculation, says Kantrowitz.

Worse yet, withdrawals from the policy are treated by the federal formula as income to the beneficiary and assessed accordingly, accomplishing the exact opposite of what you intended. So who benefits from these deals? The salesperson who earns a commission on them, says Kantrowitz. “I just don’t see any scenario in which this is a good deal.”

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