One minute, you’re holding that sweet bundle of joy in your arms for the first time. The next minute, you’re visiting colleges with your teenager. Between those nanoseconds, you’re asking yourself: How am I going to pay for Junior’s education? Read on, and you’ll discover how to start that all-important college fund.
Two Popular Savings Options
You can save for college in several different ways, but the two most common are Qualified Tuition Programs (529 plans) and Education Savings Accounts (ESAs). Each has its own restrictions, benefits and drawbacks.
Qualified Tuition Programs (529 plans): These plans are offered and operated by the state or a college in the state. One important thing to remember: You can choose a 529 plan from any state, not just the one in which you live.
Within a 529 plan, you can choose from two types of plans: savings and prepaid. A savings plan works like a 401(k) in that you invest the money in your choice of mutual funds set by the state’s 529 plan. And like mutual funds, your savings will go up and down with the stock market’s performance.
A prepaid plan lets you prepay the costs of an in-state public college. I do not recommend prepaid plans. Here’s why: Instead of giving someone else your money for years, you could be investing it. And you control those investments. You can earn more in a mutual fund than what you save by prepaying for college.
Education Savings Accounts (ESAs): Some people invest in an ESA because you can use the money for educational expenses in grades K-12, not just college. And some people prefer an ESA because there are more investing options than most 529 plans. However, the maximum you can invest in an ESA is $2,000 a year.
You can invest in both a 529 plan and an ESA. State 529 plans have few income, age, or annual contribution limits. However, there are lifetime contribution limits that vary from plan to plan. And with either savings option, you will get penalized if you use the money for non-educational purposes.
How to Get Started Saving
My best advice for starting a college fund is to talk to a financial advisor. You can open an account without their help, but their knowledge and experience are incredibly valuable. When you meet with them, here’s what will happen:
- You’ll choose your 529 plan or ESA. Any financial advisor worth their salt will know which state 529 plans are the most profitable and which will best meet your savings goals. Before you choose a plan, check to see if your state offers tax breaks if you invest in your state’s plan (sorry, no tax breaks for investing in other states’ plans).
- You’ll name the owner and beneficiary. Huh? In most cases, you (or your spouse) are the owner and your child is the beneficiary. Be sure to bring your child’s Social Security number because you’ll need it for the paperwork (and there’s lots of paperwork!). You can change the beneficiary to another family member later if there’s leftover money when Junior graduates.
- You’ll choose your investment options. With both ESAs and 529 plans, you can choose where you invest your money. My recommendation is mutual funds. You can choose a group of funds based on your risk tolerance and the length of time you’ll be investing. You’ll probably get more conservative as your child gets closer to college. You can change funds at any time, but you’ll likely pay a fee.
- You’ll set up the deposit. The minimum amount required to open a 529 plan varies from plan to plan. You can set up automatic withdrawal from your bank account and choose how frequent the withdrawal will be: monthly, every other month, quarterly or annually. You may also choose to add money as you can rather than on a schedule.
- You’ll review it regularly. Once you’ve opened your child’s college fund, you can’t put it on autopilot. Just like you keep track of your retirement investments, you need to keep track of your kid’s college fund. When you meet with your financial advisor (which you should do regularly), you can spend a few minutes reviewing the college fund and discussing possible adjustments.
One question I often hear is, “Should I stop investing for retirement so I can put more money in the college fund?” My answer is a resounding NO! Your child may or may not go to college, but you will retire someday and you need to be prepared financially. You don’t want to become a burden to your child later on, so investing in retirement first could be the most loving thing you could do.