College Savings and Investing With 529 Plan and ESA

By Pinyo, on April 1, 2009

As a new parent, I am sure you’re painfully aware of how expensive college is, and will be.  You may wonder how in the world are you going to save that huge sum needed for your child’s college education. This article is design to help you walk through each step — e.g., getting your finances in order, determining how much you should save, and how to make the most of your college savings with a practical investment plan.

Photo by Beard Papa via Flickr

Get Your Finances In Order

Don’t save for your child’s college education until you’re out of debt and have your retirement savings on track.

Before you can realistically think about saving for your son or daughter, there are two really important things you must take care of first: (1) get out of debt and (2) save for your retirement. If you don’t have these taken care of, stop right here and go read my Dave Ramsey’s Baby Steps article. Once you’re out of debt and have your retirement savings on track, it’s a matter of balancing college savings against other financial priorities.

How Much Will College Cost

Before you consult a college savings calculator, there are a few things to think about.

First, what do you feel is the right level of contribution for you as a parent versus your child? Here’s a great article by Kevin Geary that discuss parents versus child’s responsibility when in come to college savings. Each person will have a different answer for this. I personally think contributing enough to support 4-years public college is the least I could do, and letting my son pay for the rest if he wants more.

Second, what is the level of education you’re planning to support?

• 2-year versus 4-year
• Community, public, or private

Now, try this college savings calculator by College Board and plug in your numbers. For example, 15 years from now a 4-year in-state public college will cost $164,209, using college cost inflation rate of 5%.

How Much Do I Need To Save For College

Consider the calculated college cost number your stretch goal and it’s not the end of the world if you can’t save that much.

Don’t panic when you see the number because this is just the starting point. Beside you don’t have to cover 100% of the expenses from your college savings account. You can pay from your then current income and by borrowing. Moreover, there are many ways to lower your child’s college education costs — i.e., advanced placement, scholarship, etc.  Lastly, you should be saving for the expected family contribution (EFC) and not the full cost of college education.

In our example, let’s assume that we want to save about 50% of the total cost, or $82,000.

Here are more resources on spending less for college:

• 10 Tips for Frugal Students at Being Frugal
• Top 10 Ways to Save Money in University/College at Million Dollar Journey
• Seven Ways To Fund College Without A College Savings Fund at Frugal Dad
• How To Pay For College When You’re On Your Own at One Caveman’s Financial Journey
• You don’t have to pay for your child’s college education at Rocket Finance

Basic Saving and Investment Plan For College

Depending on when you start, you could have 17 years or more to build up your child college fund — actually more if you’re proactive and start saving before your child is born. This gives you long enough time horizon for you to invest fairly aggressively for this goal — as opposed to just saving it in an online savings account with the highest rate.

For this discussion, your investment plan could be as simple as:

• Contribute $x per month.
• Start with 100% in equities and shift 5% per year to cash and fixed-income investments.
• Rebalance your portfolio once per year.
• Shift to 100% fixed income when your child is ready to enter college.

For example, here is a possible investment plan to save $82,000 in 15 years:

• Contribute $300 per month.
• Start with 10% in equities and shift 5% per year to cash and fixed-income investments. Notice the expected return on investment that declines over the year due to greater portion invested in fixed-income.
• Rebalance your portfolio once per year.
• Shift to 100% fixed income when your child is ready to enter college. This will help you preserve your investment and prevent any untimely loss due to stock market downturn.

How To Save For College

Now the question is exactly where should you be saving money earmarked for college. The good news is the government wants you to save college and offers some excellent tax-advantaged options. Two most popular ways to save for college are 529 college savings plans and Coverdell Education Savings Accounts (ESA).

There are other ways, such as, Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Generally, you will have to consider pros and cons before choosing the method, or a combination, that work best for you.

Personally, I think 529 Plan and ESA are the best. Here’s a high level comparison between the two. Please note that I am not discussion 529 Prepaid College Tuition Plan here.

What if my child does not go to college?

If this happens, you’ll find that 529 college savings plan is a lot more flexible than the Coverdell ESA. With a Coverdell account, the beneficiary must use the assets by age 30, or a new beneficiary must be named.

With a 529 savings plan, you can leave the money in the beneficiary name for as long as you want. You can also name new beneficiary who is a member of the current beneficiary’s family, including yourself, at any time.

If you withdraw the money for non-qualified expenses, you will pay ordinary federal income tax plus a 10% penalty on the earnings.

Please note that this is very general and there are many caveats to the actual rules.

More College Savings Tips

Here are a few tips to consider when saving for college:

1. Never put college savings ahead of your retirement savings
2. Saving for a home purchase should take priority over college savings (I’ll discuss this in another article).
3. If you can’t save enough to meet your goal, try reducing your expenses and increasing to your income.

Other excellent resources:

• College Savings Plans: 529 vs. Coverdell ESA at Cash Money Life
• 10 Questions About College Savings Plans at Good Financial Cents
• College Expenses: Should parents pay for their children’s tuition? at Bible Money Matters
• Education Investment Accounts: Canadian RESP Vs. American 529 Comparison at Four Pillars
• How to open a 529 college savings plan for your children at My Dollar Plan

This article was featured in the Carnival of Personal Finance at ABCs of Investing.

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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