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How to Invest for CollegeIntroduction
With some smart planning, the School of Hard Knocks won't be the only educational institution your kids will be able to afford.
In this course, we'll cover how to determine how much you'll need to invest for college and what the right mix of investments should be, different investment vehicles you can use for college funding, and how to alter your portfolio as the big day draws near.What You'll Need
The first thing you need to do is take a deep breath and determine what college will actually cost.
Review Portfolio 102, which discusses in detail how to calculate the cost of your goals. Whether you're saving for retirement, for a home, or for your child's education, goal setting comes down to answering a few key questions:
Next, you need to figure out what asset mix will get you to that goal. If you have not taken Portfolio 105: Determining Your Asset Mix, you may want to take a few moments to do so now.
Now you know what your goal will cost and what your asset mix should be. Next, you need to choose the best college-saving plan for your situation.Choosing a College-Saving Plan
Several years ago, there were only a few education-savings programs. Parents picked between investing with tax-deferred accounts, such as United Gifts for Minors Act (UGMA) or United Trusts for Minors Act (UTMA), or squirreling money away in taxable accounts.
Today, with options such as the Coverdell Education Savings Account, 529 plans, and state-run Prepaid Tuition programs, parents have a new dilemma: How do they choose among the many college-investing options?
Ideally, you want to choose a plan that will provide the highest investment returns and the best tax benefits. At the same time, you don't want to jeopardize your child's ability to receive some financial aid.
When it comes to the financial-aid issue, consider your own income and future earnings. They will make up a major part of the financial-aid office's decision, and they will be considered more important than assets such as investments or home equity. High-income parents who think their children will qualify for a big financial-aid package simply because the family doesn't keep a brokerage account are sorely mistaken.
When it comes to comparing the various college-saving plans, ask five questions:
The Coverdell Education Savings Account (formerly known as the Education IRA) is a creation of the Taxpayer Relief Act of 1997. As the name implies, it's tailor-made for college savings.
Here are the answers to the five college-savings-plan questions:
The Education Savings Account is a good choice for anyone who qualifies. However, saving just $2,000 per year for college may not get your kid very far. As a result, the Education Savings Account should only be one part of your college-saving plan.Section 529 Plans
Also known as qualified state tuition programs, 529s are the newest thing in college savings. They are offered in all 50 states, although you needn't necessarily use your own state's plan--although there could be state-tax benefits if you stay with an in-state plan.
Individual states sponsor 529 plans. The state sets contribution limits and investment guidelines that the plan must follow. These plans are then administered by an investment company of the state's choosing. Fidelity, TIAA-CREF, and Vanguard all administer 529 plans, for example.
Because there's such variety among plans, you need to do some legwork. You don't need to become footsore, though--check out Morningstar.com's 529 plan data at http://529.morningstar.com/state-map.action. It includes both qualitative and quantitative analysis of state plans, offering recommendations for both in-state and out-of-state investors.
The answers to our college-savings-plan questions:
These plans are great, especially for high-income investors. Many plans allow you to contribute as much as $200,000 or more up front (though the gift tax may apply for large contributions), and withdrawals for qualified expenses aren't taxed under current law.
Evaluate a 529 plan's investment options as you would any mutual fund. Understand how they invest, examine their performance, and understand all fees associated with them. And remember that you can shop around--you don't have to invest in your state's plan.State Prepaid Education Plans
Like 529 plans, Prepaid Tuition Plans are also state-sponsored. These plans differ significantly from the other options here, because they allow you to lock in the cost of college at today's prices. They can be good options if you think your child will attend a state university. (In a state-sponsored program, your child needs to go to college in that state to get the maximum benefit of this program.)
The answers to our questions:
Along with creating the Education IRA, the Taxpayer Relief Act allowed investors to draw on traditional IRAs for education expenses without incurring early withdrawal penalties. Acceptable uses for traditional IRA proceeds include tuition, supplies, and--for students enrolled at least part time--room and board.
This may be a good fallback way to save for college. It isn't the ideal way, though, given your other options. If you qualify for the tax break that a traditional IRA affords, you should probably be using this vehicle as a means for funding your own retirement instead of your child's education.Roth IRAs
Thanks again to the Taxpayer Relief Act, you can also draw on Roth IRAs for education expenses.
Using the Roth IRA as a college-savings tool suffers from the same drawbacks as using a traditional IRA for college funding. And with a Roth IRA, you can only withdraw your contributions to the account without penalty, not the gains your investments have made.Uniform Gifts to Minors Act
Most states have variations on the UGMA (sometimes called a UTMA), which allows anyone to transfer ownership of assets or an investment to a minor.
The biggest problem with the UGMA is the control you surrender. If junior would rather spend the account on a new car rather than college, he can. It's his money.Turn Tame When the Time Is Right
If your college savings portfolio tanks in the fall of freshman year, you won't have the luxury of waiting for it to rebound. That's why a college portfolio should become tamer as the student gets closer to matriculating. The idea is to protect the gains instead of angling for more.
To rein in the portfolio, shift assets into a short-term bond fund. If the markets turn ugly, the bond fund won't lose much--if any at all.
Start moving some of the portfolio's assets seven years before you need to make that first tuition payment. That should cushion you against a prolonged market slump.
In fact, at that seven-year point, your child's college education isn't a long-term goal; it's an intermediate-term goal. As such, the portfolio should begin to look more like an intermediate-term portfolio than a long-term portfolio.
To learn how to craft an intermediate-term portfolio, review Portfolio 209: How to Invest for Intermediate-Term Goals.
|1||When choosing a college-savings plan, you want:|
|a.||A plan that will offer the best possible returns|
|b.||A plan that will provide you with the best tax advantages|
|c.||Both A and B|
|2||Which of the following plans usually invest only in bonds?|
|a.||Coverdell Education Savings Accounts|
|b.||State Prepaid Education Plans|
|3||What's the biggest drawback to a Uniform Gift to Minors Act account?|
|a.||You eventually surrender control of the account to the recipient.|
|b.||You can only contribute $500 to a UGMA account in a year.|
|c.||Withdrawals are taxed at your rate, not the recipient's rate.|
|4||Parents with incomes above a certain level cannot contribute to:|
|b.||Coverdell Education Savings Accounts|
|5||If you'll be sending your child to college in five years, her college portfolio should:|
|a.||Resemble a long-term portfolio|
|b.||Resemble an intermediate-term portfolio|
|c.||Resemble a short-term portfolio|
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