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Paying for college
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October 8, 2001: 7:00 a.m. ET
Use 529 plans, set up a proper portfolio and snag those scholarships.
By Shelly K. Schwartz
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NEW YORK (CNNmoney) - Saving for your child's college education. It's a daunting financial challenge, to say the least.
For most, the clock starts ticking the minute their child is born - leaving them 18 short years to set aside cash and develop a savings strategy that will meet their financial needs.
It doesn't help, either, that the cost of a college degree is growing every year.
Brian Orol, a certified financial planner with Strategic Financial Planning Group LLC in Raleigh, NC., said tuition expenses have risen between 6 percent and 7 percent a year since 1981, even as the cost of living has climbed just 2 percent annually.
At this rate, experts estimate a four-year degree at a public state school will cost between $125,000 and $160,000 by the time your newborn heads off to the dorms. An undergraduate program at a private university could cost roughly $250,000. And don't forget, it takes many students five years or more to earn their cap and gown.
"This is huge," Orol said. "There's no way to understate the importance of (saving early). It's never too early to start."
The good news is, it's a more attainable goal than it sounds. Through the magic of compounded interest, experts say you'll be able to cover the tab for an undergraduate education at a public university by saving just $300 per month over the next 18 years, assuming an 8 percent rate of return. If your investments grow 10 percent per year, you'll only have to pocket $240 per month.
Better yet, Orol insists, there are plenty of programs in place to help you meet your savings goals - from tax-free savings tools to low-interest loans. You just need to know where to look.
Tax-friendly tools
One of the first places parents should turn is the prepaid tuition plan. Such investment options, also known as 529s, allow parents or grandparents to contribute after-tax dollars into a pre-selected, state-sponsored portfolio that consists of equities and bonds. Most states offer their own 529 plan these days and many automatically adjust your level of risk based on the age of your college-bound child.
Previously, earnings in 529 plans grew tax-deferred until withdrawn, at which time they were taxed at the student's rate of 15 percent. Under the recent Tax Relief Act Of 2001, however, earnings in such funds can be withdrawn tax-free starting next year if used to pay for qualified education expenses.
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 FLEXIBILITY
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In earlier years, college students were forced to attend the state school where contributions to a 529 plan were made. Most residency requirements, however, have since disappeared.
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"We think these are the best plans out there," Orol said.
Education IRAs, of course, also enjoy a tax-favored status, allowing parents who make after-tax contributions to withdraw those funds, plus earnings, tax-free if used to pay for college tuition.
As part of the Tax Relief Act of 2001, Congress increased the annual contribution limit for education IRAs to $2,000 next year from $500 today. It also raised income eligibility limits for married couples.
Currently, the ability to contribute to education IRAs phases out for couples with adjusted gross incomes between $150,000 and $160,000. Starting in 2002, however, that phase-out range will jump to $190,000 to $220,000, notes tax columnist Gary Klott.
"We are very encouraged that the education IRAs have jumped to $2,000; that's a great improvement," Orol said. "But 529s now allow you to take money out for college that is free of federal tax. That's an incredible bonus."
He adds, too, it's a good idea to have more than one source of college funds.
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"We encourage parents to set up at least two types of college savings accounts. But the rules are that you cannot open an Education IRA in the same year you do a 529 plan."
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Brian Orol, CFP |
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Investing for tomorrow
Setting up the right investment portfolio, of course, is also paramount when it comes to college savings. Since the time horizon you have to invest is much shorter than it is for retirement accounts, the asset allocation strategy is different as well.
If your child is an infant, for example, Orol said it's wise to put 90 percent of your college investment into individual stocks or equities, leaving 10 percent in a money market fund where it will receive a guaranteed, though lower, rate of return.
"We like to create a growth mix for our equities, that will have one piece aggressive, one piece growth and one piece conservative so that you end up with an average rate of growth," he said. "We don't want to take that high a level risk because this is money that you can't afford to lose."
When your child turns 4, Orol said you should begin moving 5 percent of your equity holdings per year into a money market fund or government bonds.
That will leave you with roughly 75 percent of your college account in lower-return, safe-haven accounts and 25 percent in equities by the time little junior enters ninth grade.
At that time, when he or she becomes a high school freshman, it's wise to further insulate your holdings by taking one year's worth of college expenses off the risk table. Slide that money into fixed-income securities and money market funds, doing the same during their sophomore, junior and senior years in high school.
When your child reaches college, you should leave just 10 percent of your college funds in the stock market - providing the flexibility and growth potential needed in case your child takes a year or two off.
Low-interest loans
No matter how well you invest and save, however, chances are good you'll still need some help - especially if you've got more than one child. That's where financial aid comes in.
In most cases, the federal government offers the most favorable loans for students and the parents of college kids who are paying their tuition.
Among the most popular is the Stafford Loan, which allows dependent undergraduates to borrow up to $2,625 their freshman year, $3,500 their sophomore year, and $5,500 for each remaining year with a flexible repayment option. According to FinAid.com, the variable interest rates on such loans caps out at 8.25 percent.
Most campuses also offer their own federally-backed loan programs to students in severe financial need - the Perkins Loan. The program charges a nominal 5 percent interest rates with no fees and sets the limit at $3,000 annually for undergraduate students.
Lastly, FinAid.com notes that parents of dependent students also have the Parent Loan for Undergraduate Students (PLUS) program at their disposal. With interest rates that cap at 9 percent, PLUS loans are the sole responsibility of the parent. They require repayment to begin 60 days after the funds are fully disbursed, with a repayment term of up to 10 years.
If you still don't have enough, between your savings and the federal loan programs, you can always turn to the private sector. Banks offers myriad alternative loans for educational purposes, but expect to pay higher interest rates.
The scholarship shuffle
All parents, of course, hope their kids qualify for a scholarship - few do. Nearly $1 billion has been earmarked for grants and scholastic awards to qualifying students, but only 1 in 25 students who apply for scholarships actually land any cash.
The Web site, which offers a searchable database of undergraduate scholarships and graduate fellowship grants, notes that such awards are generally are reserved for students with special academic, athletic or artistic qualifications. They are also distributed for specific fields of study, members of underrepresented groups and those who can demonstrate financial need.
But it's always worth a shot.
The average amount received is about $1,600, according to Mark Kantrowitz, creator of FinAid.com.
He notes, too, that students should steer clear of financial aid services that charge a fee. All of the information they need is available for free either online or at the library.
Dipping into your nest egg
Finally, it may be tempting, but financial planners advise against raiding your retirement funds to cover short-term bills, including education. That not only robs your nest egg of compounded earnings potential, but it could end up costing you big bucks in early withdrawal penalties.
"Don't tap your 401(k)," Orol said. "We strongly believe in the power of compounding over time."
An individual who builds $200,000 in their 401(k) during a 20-year span, he said, will earn $10,000 annually during their Golden Years if their investment returned just 5 percent. If they pull out $50,000 to pay for their child's college education, however, that same investment will produce income of just $7,500 per year.
"It hurts you a little today and a lot more down the road," he said.
Orol said he recommends that clients approach their long-term savings strategy as a three-step process. First, he said, they should contribute to their 401(k) enough to get the company match and then they should fully fund a Roth IRA. With whatever money remains, they should then apply it toward maximizing their 401(k) to enjoy the tax-deferred growth.
The benefit of a Roth, is that it allows taxpayers to withdraw their principal for educational purposes before they turn 59-1/2 penalty-free. Any earnings you take out, however, will be subject to regular income tax.
"That's good basic planning for anyone," Orol said. "That way you get every tax advantage and it does grow tax-deferred and you've set yourself up with multiple income streams." 
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