Return to:Previous Page
Morningstar.com's Interactive Classroom

Course 210
How to Invest for College

Introduction

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 answeringa fewkey questions:

  • How much will the goal cost each year?
  • How many years will you be tapping into this portfolio to pay for the goal?
  • What will the total cost of the goal be?
  • What will inflation do to that total cost?

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:

  • How much can I contribute to the plan?
  • What are the plan's investment options?
  • What are the taxes?
  • Who controls the money?
  • Can the money in the plan be used for anything other than education?

Education Savings Account

The CoverdellEducation Savings Account(formerly known as theEducation 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:

  • You can usually contribute up to $2,000 per year to an Education Savings Account, possibly less depending on your income. A child can only be "funded" by $2,000 per year, though. So you and grandma cannot each invest $2,000 in an Education Savings Account for your son each year.
  • You can invest the Education Savings Account in just about anything.
  • Although you pay taxes on contributions, withdrawals are tax-free.
  • The recipient (the child going to college) technically controls how the money is spent, but he or she can only use it for education. If he/she doesn't use the money, you can transfer the account to a relative who will use the money for education.
  • Money in the account can only be used for education.

The Education Savings Account is a good choice for anyone who qualifies. However, saving just $2,000 per year for collegemay notget 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 bestate-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:

  • The amount you can contribute varies from plan to plan. The best news: Anyone can contribute to 529 plans, regardless of your current income.
  • When it comes to investment options, each state has its own roster. If the lineup in your state's plan doesn't suit you, choose a plan outside your home state.
  • Withdrawals for qualified expenses are tax-free from federal taxes.
  • You're in control, because you select the plan and can determine how much you'll contribute.
  • Proceeds of the account can only be used for education. However, you can transfer the account to another child if the original recipient doesn't use it.

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:

  • The amount you can contribute varies from plan to plan, and there are generally no income restrictions.
  • Prepaid Tuition Plans usually invest in state-backed bonds, because they aim only to keep up with rising in-state university costs.
  • Gains are tax-deferred and withdrawals are tax-free under the current tax code.
  • Unlike the other options here, you cannot control what the plan invests in. Although the account is technically in your child's name, you retain control of it.
  • The money can be used for college funding only. If your child decides not to attend a state college, you can transfer the money to another child's name.

Traditional IRAs

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.

The answers:

  • Check the IRS's web site for current contribution limits.
  • You can invest an IRA in anything.
  • Withdrawals will be taxed at your regular income-tax rate. Some or all of your contribution may be tax-free, depending on your income.
  • It's your account. You decide how the money is spent, if at all. If your child doesn't go to college, you can hold on to the IRA for your own retirement.
  • If you withdraw the money and don't use it for eligible college costs, you'll be hit with a penalty.

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.

  • Check the IRS' web site for contribution limits.
  • You can invest a Roth IRA in just about anything.
  • Withdrawals of contribution (not earnings, though) are tax-free. Contributions are subject to taxes.
  • The account is under your control. You decide how the money is spent, if at all. If your child doesn't attend college, you can use the Roth IRA to fund other goals

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.

  • You can contribute up to $13,000 in 2012 to a UGMA account, $14,000 in 2013.
  • You can transfer cash, any mutual fund or stock, or property to the account.
  • Withdrawals are taxed at the recipient's rate.
  • The money belongs to the recipient, not to you. You can, however, act as a custodian until the recipient reaches a set age. That age varies from state to state.
  • UGMAs can be used for anything (except parental obligations), not just college costs.

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.

Quiz 210
There is only one correct answer to each question.

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
c. 529 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:
a. UGMAs
b. Coverdell Education Savings Accounts
c. 529 Plans
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
To take the quiz and win credits toward Morningstar Rewards go to
the quiz page.
Copyright 2006 Morningstar, Inc. All rights reserved.
Return to:Previous Page