There are many methods of saving for a child’s college education. Options include 529 college savings plans, prepaid tuition plans, Coverdell Education Savings Accounts, taxable bank and brokerage accounts, savings bonds and other savings vehicles. Even within a particular type of college savings plan, such as a 529 plan, there may be many available options, with state 529 plans open to investment by families from other states. The family must compare the various college savings plans to find the one that is best suited for them.
The ultimate goal of investing in a college savings plan is to maximize the amount of money the family will have available to pay for a child’s college costs. This involves maximizing the after-tax return on investment while appropriately managing the risks.
The most important criteria for choosing a college savings plan include:
Low fees. A 1% fee on a college savings plan may seem low, but if the annual investment returns are only 5%, the fee is diverting a fifth of the return on investment. The fees should be subtracted from the investment returns when comparing options based on return on investment. For example, an advisor-sold 529 college savings plan may have slightly higher earnings than a direct-sold 529 plan, but it also has higher fees. The net return on investment after subtracting the fees is usually highest on a direct-sold 529 plan, not an advisor-sold 529 plan.
Tax advantages and restrictions. The tax treatment of an investment can likewise affect the net return on investment. Do earnings accumulate on a tax-deferred basis? Are qualified distributions tax-free? Are non-qualified distributions taxed at the beneficiary’s rate or the account owner’s rate? Are contributions to the college savings plan deductible on the contributor’s state income tax return?
Managing risk. Investments can not only increase in value, but also decrease in value. For example, the S&P 500 decreased by almost 40% in value in 2008. It took four years for the S&P 500 to recover from these losses. Some investments, such as Certificates of Deposit (CD), have little or no risk of loss to principal. Other investments, such as guaranteed investment options in some state 529 plans and Treasury Inflation-Protected Securities (TIPS), may provide a guaranteed minimum return on investment. But most investments with the potential of keeping pace with increases in college costs involve a potential risk of loss to principal. So instead of avoiding risk entirely, investments must seek to minimize the risk.
A popular approach to managing risk is to use an age-based asset allocation. An age-based asset allocation starts off with an aggressive mix of investments when the child is young and less money has been accumulated. There is also more time available to recover from any potential losses. As the child grows older and college approaches, the investments are shifted to a more conservative mix of investments, protecting much of the investments from potential losses. For example, a typically age-based asset allocation might start off with 80% of the investments in an all-stock fund, gradually changing the asset allocation each year until no more than 20% of the investments are in stocks when the student is about to enroll in college. The rest of the money should be invested in conservative investments, where there is no risk of loss to principal.
Financial aid impact. Some investments are reported as assets on the Free Application for Federal Student Aid (FAFSA) and some are not. Some distributions from a college savings plan are reported as income on the FAFSA and some are not. Each type of college savings plan can have a different impact on eligibility for need-based financial aid.
Contribution limits. What is the maximum amount that can be contributed annually? What are the cumulative contribution limits? For example, contributions to a Coverdell Education Savings Account are capped at $2,000 per year, while 529 college savings plans have no annual limit other than the annual gift tax exclusion, with an option for five-year gift tax averaging. Most 529 plans have cumulative contribution limits equal to seven times the highest annual cost of attendance in the state or nationally. Minimum contribution thresholds may also matter for families who have limited means to save. Does the college savings plan provide automatic monthly contributions in addition to lump sum contributions? Who can contribute to the college savings plan?
Restrictions on use of funds. Some college savings plans have restrictions on the tax-free use of funds. For example, Coverdell Education Savings Accounts have age restrictions on qualified distributions from the college savings plan. Prepaid tuition plans may limit the family to the refund value of the plan if the child decided to enroll in a private non-profit college or an out-of-state public college. What happens if the child wins a scholarship, doesn’t go to college or dies?
There are two tools that can help families choose a college savings plan.
Comparison of College Savings Options. This chart highlights key differences between the main types of college savings plans: 529 college savings plans, prepaid tuition plans and Coverdell education savings accounts.
Checklist for Choosing a College Savings Plan. This checklist allows families to fill in details about each college savings plan under consideration, helping to highlight the differences and clarify the decision-making process.
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