Saving For College

According to the Bureau of Labor Statistics, the tuition component of the Consumer Price Index (CPI) increased by 8% per year, on average, from 1979 to 2001. This means that children born today will face college costs that are 3 to 4 times current prices by the time they matriculate.

Parents should expect to pay at least half to two-thirds of their children's college costs through a combination of savings, current income, and loans. Gift aid from the government, the colleges and universities, and private scholarships accounts for only about a third of total college costs.

Accordingly, it is very important that parents start saving for their children's education as soon as possible, even as early as the day the child is born. Time is one of your most valuable assets. The sooner you start saving for college, the more time your money will have to grow.

If you start saving early enough, even a modest weekly or monthly investment can grow to a significant college fund by the time the child matriculates. For example, saving $50 a month from birth would yield about $20,000 by the time the child turns 17, assuming a 7% return on investment. Saving $200 a month would yield almost $80,000.

It is less expensive to save for college than to borrow. Either way, you're setting aside a portion of your income to pay for college. But when you save, the money earns interest, while when you borrow, you're paying the interest. Paying for college before your child matriculates definitely costs much less than paying for college afterward. Saving $200 a month for ten years at 7% interest would yield $34,818.89. Borrowing the same amount at 6.8% interest with a ten year term would require payments of $400.70 a month. At 8.5% interest the payments increase to $431.70 a month. So if you elect to borrow instead of saving, you will be paying 1.7 to 2.6 times as much per month!

529 College Savings Plans

Although in the news a lot, 529 College Savings Plans have some major disadvantages over other types of college savings plans.

The disadvantages common to section 529 prepaid tuition plans and section 529 college savings plans are as follows:

529 Plans are counted against either the parent or student (depending on whose name the account is opened under) when determining the amount of Financial Aid given to families.
The earnings portion of non-qualified withdrawals is taxed as ordinary income at the account owner's rates, plus a 10% tax penalty. If the beneficiary dies, becomes totally and permanently disabled, the 10% tax penalty is waived. If the beneficiary receives a scholarship, the 10% tax penalty is waived on distributions up to the amount of the scholarship. States may also assess their own penalties in addition to income tax on the earnings portion of the distribution.
Section 529 plan accounts are not necessarily protected from creditors of the account owner or beneficiary. Such protections vary from state to state. For example, Medicaid might be able to use the funds if the account owner needs nursing home care and has no other funds available.
Both types of plans have been around for just a few years, so it is difficult to evaluate their long-term investment performance.
Less disclosure is required for the managers of section 529 plans than for other types of investments.

The disadvantages of section 529 college savings plans are as follows:

State tax benefits may be limited to the state's own section 529 college savings plan.
You are limited to the investment options provided by the plan.
Although the more aggressive investment options offer a greater potential return, they also offer a greater potential risk. Except for principal protection portfolios like money market accounts and guaranteed investments (offered by a few states), the principal you invest is at risk. If the program's manager makes bad investment decisions or the stock market declines, you could lose money.
Expenses and sales charges may be higher than what you'd pay if you invested the money yourself. Some plans charge excessively high sales loads of as much as 5% or 6% and management fees of as much as 2% a year.

The disadvantages of section 529 prepaid tuition plans are as follows:

Prepaid tuition plans have a very high impact on financial aid eligibility, because they are considered a resource. Distributions from a prepaid tuition plan reduce need-based financial aid dollar for dollar. (This may change in the future.)
Prepaid tuition plans may offer a return on investment that is not as good as other investments. A family with financial savvy might be better off investing the funds on their own through a section 529 college savings plan.
Your investment in a prepaid tuition plan may not meet the full cost of private or out-of-state colleges. In most states the plans are geared toward in-state public colleges.
The enrollment period may be limited.
There may be penalties and/or reductions in investment returns for non-qualified withdrawals or account cancellation.
Many state prepaid tuition plans are limited to tuition and fees, and do not include savings for room and board. So the family may need to plan separately for these additional costs.
In many states the account owner or the beneficiary must be a state resident when the account is opened.
Maximum contributions are much lower than for section 529 college savings plans.
Many prepaid tuition plans include a 10-year time limit from the date of expected college entrance or high school graduation. Another less common limit is a requirement that the funds be used by the time the beneficiary reaches age 30.