This August, my daughter celebrated her fifth birthday and my son turned 2. Their birthdays have already established themselves as days of more than just balloons and presents; it's also the time when my husband and I reevaluate their college savings accounts. I'm gearing up to do it again this year.
Emma's and Sammy's savings consist largely of mutual funds plus a few blue-chip stocks that my dad bought for them. And we recently started a 529 Plan. Their portfolios have been hit hard by the recent stock market gyrations, and it's pretty scary to think about how much college will cost in 14 years.
What It Will Cost
Tuition and fees at private four-year colleges rose an average of 9.8 percent in 2003-2004, and 5.7 percent at public colleges, according to The College Board. And the U.S. Department of Education says between 1991-92 and 2001-02, prices at public colleges rose by 21 percent, and prices at private colleges increased by 26 percent, after adjustment for inflation. And at an inflation rate of 6 percent a year, my kids will be paying through the nose by the time they're freshmen.
Exactly how much? Visit the FinAid.com Web site for some estimates. You can plug in numbers to see what it will cost for your little genius. If, for example, my child wants to go to New York University, my alma mater, it will cost about $373,198 for four years. Fortunately, most families don't foot the entire bill on their own. Some seven million students receive financial aid every year, says the Coalition of America's Colleges and Universities. Financial aid covers about 40 percent of college costs for full-time students. Grants cover another 20 percent. Then there are scholarships, loans, and other sources of money, like your own savings.
That's what prompted our early start. I know the kids may get some scholarships or financial aid, but the basis of our savings plan was a worse-case scenario -- as if we'd be shelling out the entire cost. If luck is with us and Emma and Sammy get a few scholarships and some other aid, all the better. Then their unspent college money can be saved to pay for a wedding, a down payment on a first house, or some other future goal.
Where to Save
The choice of investing in some solid growth mutual funds was an easy one for me. We've got a long time horizon, and the stock market is historically the best place to be for long-term investing. The tough part was deciding what kind of account the money should go into. Should I keep the money in my name, pay the taxes every year, and then distribute the funds when the kids would need them? Or should I put the money in a custodial account in their names, let them pay the taxes at the lower child rate, and then take my chances that they won't opt for red Corvettes instead of tuition bills come age 18? And then there's the 529 Plan, which most financial planners are touting as the best thing since sliced bread.
529 Plans allow you to save money, which will grow tax-deferred. The funds are withdrawn tax-free if used for education (unless Congress doesn't renew the provision in 2010). The advantage of 529s, in addition to the tax treatment, is the flexibility. You can contribute a lot of money. Depending on the state plan you choose, you can contribute more than $200,000. You can even change the beneficiary of the account from one child to another as each goes to college. Each state plan offers different investment choices, mostly mutual funds. You can even choose age-appropriate investments that the investment company will change as the child nears college age. And you remain the owner of the account, so you retain control of the money and how it's spent.
Then there are custodial accounts. The most popular kinds of custodial accounts are the Uniform Gift to Minors Account (UGMA) and the Uniform Transfer to Minors Account (UTMA). The main difference between the two is that the UTMA lets you contribute assets other than cash. For college saving, an UGMA usually is the way to go.
Like an IRA, a UGMA is just an umbrella within which you can choose a variety of investments. By putting funds into a UGMA, you reap some tax savings. The first $750 of annual earnings in a UGMA is tax-free. The second $750 is taxed at the child's rate, which usually is 10 percent -- less than most parents pay. Anything over $1,500 in earnings is taxed at the parents' rate. Once the child turns 14, the child's rate applies to all annual earnings over $750.
The disadvantage to these accounts is that once your child turns 18 or 21, depending on where you live, the money is his. He can do anything he wants with it, and you have no say in the matter. Once you put the money in, it's irrevocable. You can't take it back, even if Junior turns out to be a rotten kid.
The other recent addition to college savings plans is the Coverdell Education Savings Account, formerly called the Education IRA. You can invest up to $2,000 per year per child in 2004 in a Coverdell, which grows tax-free. If the funds are used for education-related expenses -- such as tuition, room and board, and supplies -- the withdrawals also are tax-free. Like a UGMA, a Coverdell is an umbrella -- you pick the investments that go in it. It's a great starting point, but because of the $2,000-per-year investment limit, it probably won't meet all your savings needs. An investment of $2,000 per year at 8 percent over 18 years will grow to $80,892 -- which may or may not be enough to pay all the bills you'll be facing.
Playing Catch Up
If your child will be college-bound in five years instead of 15, there's still plenty you can do to prepare.
Don't give up. You may have lost out on some compounding time, but that doesn't mean you should just throw in the towel. Start saving today. Even if it's just $25 or $50 a month, set up an automatic investment plan so the money is taken out of your paycheck or checking account before you have a chance to spend it.
Get Junior into the act, too. If your child has a summer job, offer to match dollar-for-dollar whatever money he's able to save for college. It'll give him the incentive to pitch in, and together you can learn about investing as you watch the money grow.
Watch your asset allocation. Invest some of the college money in growth funds, of course, but because your time horizon is relatively short, consider putting most of the money into safer vehicles such as bonds.
Don't forget about the grandparents. If you fear you'll fall short when the college bills arrive and you know your parents are planning for your kids to inherit some money from them, maybe they'd be interested in giving the money to your kids today. Each grandparent can gift up to $11,000 to as many people as they'd like each year.
Most of my kids' funds are in UGMAs. The UGMA choice is sort of a gamble. When the kids apply for financial aid, colleges will assume that 35 percent of all funds in their names are earmarked for college costs. That means that they may get less aid because of their assets. If the money were in my name, institutions would assume that only 6 percent is earmarked for college. So why did I put the accounts in their names?
I'm hoping that as my husband's and my careers blossom over the years, we'll be making more money. That means we'll qualify for less college aid anyway. So today, I'll take the tax savings. But I don't intend to invest all of Emma's college savings in custodial accounts. Later money will be invested in my name, so the kids' portfolios won't be too healthy come college time.
I've also invested in a Coverdell for both kids. Now that they've raised contribution limits, I plan to continue contributions annually to take advantage of the tax-deferred and tax-free treatment.
529 Plans weren't very popular when I started saving for the kids, but now, I'm wondering if I should shift money from the UGMAs to a 529. My husband's job recently started a program allowing him to have money taken directly from his paycheck to be invested in a 529 plan. We've started that program. If we did transfer the UGMA money, the funds would be tax-free upon withdrawal and we wouldn't pay taxes on the growth every year as we do now. But unlike regular 529 contributions, the transferred funds would still be owned by the kids.
I've kept up with the performance of the kids' investments, and despite the losses of the stock market, I'm happy with the asset allocation. We're losing money now, but we still have a long time horizon and I'm willing to wait it out. I plan to contribute again this year to the Coverdell, and I'll try to add more money to the 529, in addition to what's taken out of my husband's paycheck. If I ever have extra money, I'll probably start investing some college money in a new account under my name so they will have a better shot at some financial aid.
And by having some of the funds in my name, if she decides to buy a new car with her UGMA money, at least I can take comfort in knowing she won't be able to afford a Corvette. A Saturn or a Kia maybe, but definitely not a Corvette.
Karin Price Mueller is the author of Online Money Management (Microsoft Press, 2001).