Kick Sallie Mae to the Curb!

28 Jun Kick Sallie Mae to the Curb!

Funding college without student loans.

Written by Matt Wegner
Founder and Lead Counselor, Matt Wegner Coaching,

The cost of attending college is rising more and more each year. Just a few weeks ago, the University of Wisconsin school system announced a 5.5% increase in tuition alone for next year. That doesn’t include rising fuel costs and cost of living increases. That’s less than average (nationwide college tuition rises 7% each year), but either way the cost of education is still rising faster than inflation. If you don’t have a plan for funding college, now’s a good time to start planning.

Bye Bye, Sallie Mae!

So what options are there for parents who want to invest for their children’s college education? Here is a brief rundown of the most common ones.

An Educational Savings Account (ESA) is the option I recommend most often. Nicknamed the Education IRA, the ESA allows you to invest $2,000 annually in a mutual fund for college expenses. The money you invest grows tax free, which is a great advantage. For example, if you invest $2,000 each year from your child’s birth to age 18, you’ve invested $36,000. Over the 18 year investment period, your money will have grown to over $126,000 (assuming 12% rate of return). That’s essentially an increase in income of $90,000 that you won’t pay taxes on when you pay for the child’s college expenses.

The 529 Plan. There are several types of 529 plans, but the only one I recommend is the type that works like the ESA. The advantage to the 529 is you can contribute up to $10,000 per year. Some states also offer incentives above the tax free growth of your investment. Wisconsin, for example, offers a state tax exemption for contributions up to $3,000. The major disadvantage of 529s, though, is your investment options are very limited. That’s why the only 529 I recommend is the one where you are in control of the investments.

With the ESA and 529 there are income restrictions that apply. Parents must make less than $200,000 (married filing jointly) to contribute to these accounts.

The Uniform Transfer to Minors Act (UTMA) account, also called a UGMA. This allows you to open a mutual fund in a child’s name while you act as the custodian of the account. The money grows and is taxed at the child’s tax rate until age 21, when the account is transferred to the child. This option is for parents with higher incomes that do not qualify for the ESA or 529.

College savings vehicles you should stay away from are:

a) Prepaid tuition. By paying tuition now you are locking in the cost of tuition and avoiding the rising cost. The trouble with prepaid tuition is that costs are rising 7% per year, so your return on investment is basically 7%. By investing in an ESA or 529, you get tax free growth plus the opportunity for a much higher rate of return from investments you choose.

b) Savings bonds and savings accounts. Both have a lousy rate of return, and as with prepaid tuition, are far outperformed by ESAs and 529s.

c) Insurance policies. An insurance policy is never a good investment vehicle, despite what your agent tells you. The rates of return are usually lackluster, and are weighted down with tons of hidden fees and costs. With the advantages of the ESA, 529 and UTMA, there is no reason to save for college expenses through an insurance policy.

Funding from student loans with Sallie Mae doesn’t have to be part of your college plan.  Whatever the method you choose, it’s important to develop a plan and stick with it over time. Zig Ziglar often says, “You don’t have to be great to start, but you have to start to be great.” When will you start?

  • Katie Adcock
    Posted at 12:26h, 30 June

    Corrections to a few inaccuracies in the article:

    There are not annual limits for gifting to 529s. Usually the limits that investors look at are the federal gifting limits. In 2008, this is a gift of $12,000 per individual. A married couple can gift $24,000 to one individual. However, another advantage of 529s is that they allow you to accelerate gifting. You can gift up to five years in one year, which allows for a gift of $60,000 from an individual, or $120,000 from a married couple.

    There are no income limitations when investing in 529s. Anyone can be an account owner, anyone can be a beneficiary, and anyone can be a donor to the account.

    Also, one thing to be wary about with ESAs, or Coverdells as they are known: Unless Congress makes the current laws permanent, after 2010, many benefits of the Coverdell are going to convert back to their pre-2002 status. Particularly of note is the annual limit. This will revert back to just $500 a year.

  • Jonah
    Posted at 21:45h, 01 July

    Great stuff Matt. It can be tough to put retirement ahead of your children, but it’s the right thing to do. There are a few options available to parents that can help augment their college savings. One of those options is Freshman Fund, of which I am a founder.

    Freshman Fund is a college savings gift registry that lets friends and family gift directly into any 529 college savings plan. We give friends and family a meaningful gift option, and parents the security of additional college savings for their children.

  • Matt Wegner
    Posted at 22:23h, 02 July

    Katie, thanks for the insight and additional info. You are correct on the income limitations for 529s. There may be lifetime contribution limits in certain states, however. Each state plan is different so it is important to sit down with an investment professional before opening an account.