Funding college without student loans.
Written by Matt Wegner
Founder and Lead Counselor, Matt Wegner Coaching, www.financialexcellence.net
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?