Getting started on saving for a child's college tuition is crucial, so make it a habit early


July 31, 2005|By Eileen Ambrose

THE PROJECTED cost of sending a child to college is often so lofty that some parents are more overwhelmed than inspired to save.

Now some encouraging news. Some of those projections are based on the most expensive schools, so your tuition bill might not be as steep, according to Mark Kantrowitz, publisher of FinAid, an online provider of financial aid information.

Not only that, Kantrowitz tells parents that they don't have to save the entire tuition bill. He suggests that families aim to save a third of the expected cost, borrow another third using parent and student loans and use income and financial aid for the rest.

Tuition costs are likely to triple in 17 years, Kantrowitz said.

So, parents of very young children can look at the cost today of four years at the school their child will likely attend, and save that amount, he said.

Of course, the earlier that parents start saving the better. And that's the next step.

Saving and investment options abound, but there are four specifically designed for college. Each has pros and cons.

"Don't get paralyzed by the investment choice.

"You can always roll money from one investment into another," Kantrowitz said.

"The most important thing is to start saving and get into the habit," said Kantrowitz, who has been setting aside $250 a month for his son's college education even before the 2-year-old was born.

Here are four savings options:

College savings plans

Virtually every state has one, and almost all are open to out-of-state residents. They often are called 529 plans for the tax code that created them.

There are no income limits to participation. Investors can salt away huge sums, in some cases $250,000 or more per child.

The money usually is invested in a portfolio of mutual funds. The money grows tax-deferred, and withdrawals are free of federal taxes provided they are used for college expenses.

About half of the states, including Maryland, allow residents to deduct all or part of contributions to a home-state plan on state income tax returns.

The account is considered an asset of the owner - usually the parent - so it has less of an impact on financial aid than if it were the student's money.

How much money you end up with for college is based on contributions and how well the investments perform.

Investment choices are limited, a minus for those who like to control how their money is invested.

If a child doesn't go to college, the beneficiary can be switched to a relative of the child. Or, if you don't use the money for college, you'll owe ordinary income tax on the gains and potentially a 10 percent penalty.

Be aware, tax-free withdrawals are scheduled to expire in 2011, although legislation has been introduced to make this tax break permanent.

Critics have complained that some plans' fees are too high. And the National Association of Securities Dealers has been investigating whether brokers steered clients into plans with high fees and commissions and away from home-state plans that give tax deductions.

Prepaid tuition plans

Twenty states have a prepaid plan. "It allows you to lock in tuition rates and to not have to worry about the return on your investment," said Chris Hunter, program manager with the National Association of State Treasurers.

The plans usually require that the beneficiary or account owner be a resident, but other details vary from state to state, Hunter said.

In Maryland's plan, families can buy from a semester up to five years of tuition at a Maryland public college. The money also can be applied to private and out-of-state schools. The state also gives an income tax deduction on contributions, within limits.

A prepaid plan is also a 529 so it has the same tax-deferred growth, tax-free withdrawals and penalties.

A big drawback now is that prepaid tuition plans reduce financial aid eligibility dollar for dollar, experts said. However, proposed legislation would give prepaid plans the same favorable treatment as college savings plans in financial aid calculations, Hunter said.

Also, as the projected deficits of prepaid plans ballooned in recent years with soaring tuition and weak investment returns, a handful of states either halted or temporarily suspended new enrollment, Hunter said. In some other states, including Maryland, contract prices jumped.

Independent 529 plan

This prepaid tuition plan, managed by TIAA-CREF, was launched nearly two years ago by a consortium of private colleges. The schools, rather than the states, shoulder the investment risk, said Douglas M. Brown, president of the consortium.

Investors essentially buy certificates that cover a percentage of tuition at one of 252 participating schools. Member schools also offer a tuition discount, so investors pay somewhat less than the going rate for a year of school today. Consumers also don't pay fees, officials said.

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