With college tuition rising faster than inflation, stocks are the best investment to help your education-savings portfolio keep pace long-term.
As your child nears college age, the downside risk of stocks becomes more significant and bonds and cash should begin to play an increasingly significant role when Junior hits high school.
Keep your investments simple, and stick to mutual funds that have solid three- to five-year track records and low expenses. You can even opt to have the fund company make automatic monthly withdrawals from your bank account to force you to save.
Most planners recommend that you base your asset allocation on your child's age. If your child is eight or younger, you can keep 60 to 95% of your money in stocks. You can choose a balanced fund, which holds a prescribed ratio, usually 60-40, of stocks to bonds. Or you can choose your own mix of funds and invest proportionately. For help in finding the right mix for your savings goal, try our Asset Allocator.
When your child is between ages 9 and 13, your portfolio should get more conservative, not by moving money out of your earlier investments but directing more of your new contributions to bond funds and tamer stock funds.
When your child turns 14, start to shelter the returns you've earned so far. You can do this by moving your equity assets into money market and short-term bond funds over the next four years, so that by the time your child enters college, you are out of equities entirely and can cash out quickly.
If the bond portion of your savings has exceeded $10,000, you may consider purchasing government short-term Treasury notes directly from the U.S. Treasury, to avoid paying any management fees to a fund company.
Parents may qualify for federal tax credits that can help them defray tuition costs.
The American Opportunity Tax Credit (AOTC) and Lifetime Learning Credit are almost as good as getting money outright, since they are a dollar-for-dollar reduction of the tax you owe. And in the case of the AOTC, you may get to claim some of it even if you don't owe any taxes.
You may not, however, claim both credits in the same year for the same student.
To qualify for the AOTC in 2015, your modified adjusted gross income must be less than $90,000 if you're single or $180,000 if you're married filing jointly. (Income thresholds for tax credits are usually adjusted annually for inflation.)
The AOTC lets you slash your taxes by up to $2,500 a year per child for qualified tuition and fees paid during the first four years of college -- 100% of the first $2,000 in tuition, and 25% of the next $2,000. That means you need to have at least $4,000 in tuition expenses to get the full credit.
Up to $1,000 of the AOTC is considered "refundable," meaning you may get up to that much back as a refund if you don't owe any tax at all or if your tax bill is less than the credit.
Unless Congress changes the law, the AOTC is scheduled to expire at the end of 2017 and the less generous Hope Scholarship tax credit, which it originally replaced, will be reinstated.
The rules for the Lifetime Learning Credit are a little different. To qualify in 2015, your modified AGI must be less than $65,000 if you're single or $130,000 if you're married filing jointly. There is no limit on the number of years you may claim it.
The Lifetime Learning Credit lets you slash your taxes by up to $2,000, regardless of how many children you have in college at one time. You can take 20% of the first $10,000 in qualified tuition and fees.
Unlike the AOTC, there is no limit on the number of years you may claim it.
In recent years, parents have also had the option of taking a tuition deduction, even if they don't itemize their deductions. Technically that deduction expired at the end of 2014, but Congress may renew it.
With the tuition deduction, you may deduct up to $4,000 in qualified tuition, fees and related expenses for post-secondary education, such as college and graduate school. The deduction may be taken for yourself, your spouse or your dependents.
But there are income limitations, and if you take it you may not take other types of education tax breaks, such as the Lifetime Learning Credit.
A deduction is less valuable than a tax credit because it only reduces your tax bill by a percent of every dollar. For example, someone in the 25% tax bracket who takes a $100 deduction will pay $25 less in taxes.