The first step towards saving for your child’s future education is deciding to do it. No matter when you begin, remember to think long term. Try setting money aside on a regular basis – monthly or yearly is best. In the past decades, the options available to prudent parents have grown greatly. Most revolve around the now ubiquitous 529 plan. Let’s have a look at this option. 529 plans are now available in all 50 states. There are two types:
- “Pre-Paid Tuition Plans” allow the contributor (you) to purchase inflation-protected tuition credits from participating education providers. In essence, what you would pay now is what you will pay whenever your child enters college. While other parents fret over rising tuition costs, you can relax knowing yours are locked in. These plans limit your choices but provide the most security.
- The second plan is known as a “college savings plan.” These plans allow you to allocate up to a certain amount yearly into a special education savings account. The accounts are comparable to 401(k)s or Roth IRA retirement plans and offer many of the same exemption benefits. Instead of saving for retirement, the money in 529s is limited to education uses. Savings plans have a beneficiary – in this case, your child or a loved one – and a donor (you) who maintains control over the account. You can decide how and in what amounts you would like to save. Contributions can be placed in stocks, mutual funds or bonds.
For your child’s education, it’s probably best to choose something a bit more conservative. Some states offer their own managed plans. With a managed plan, you will pay a small management fee (like a mutual fund) but only have to worry about your yearly contribution; the plan’s paid managers are charged with obtaining returns.
When you begin to draw from the account – probably when your child begins college – any income earned from the money you initially invested is completely exempt from Federal Income Tax, no matter where you live. This is huge. Over 18 years, the exempt income can compound and result in tens of thousands of dollars saved – on top of whatever the plan has earned from its investments. Depending on which state you live in, it may be possible to exempt your yearly contributions from state income tax.
It’s important to note that saving’s plans are not protected. If the stock market goes down, your savings can go down with it. Because of this, it’s best to invest with an eye to the long term. Over the past decades, annualized stock market returns (stocks or mutual funds) have averaged between 6 or 7 percent. Because your income in these funds is exempt from at least Federal Income Tax, your returns can be even higher. A parent with a newborn who in 1994 invested $50,000 in a fund that tracks the S&P 500 (a common index) would have seen annualized returns – despite the tech bubble bursting and the financial crisis – of over 7 percent. That same $50,000 would be worth at least $123,000 by the time their child entered college in 2012. If that $50,000 was placed in a 529 plan, all of the $83,000 in gains would have been exempt from Federal and possibly state income tax.
Do the research and decide for yourself.