How to avoid drowning in college debt

Flickr user 401K(K) 2012

(MoneyWatch) College tuition costs have risen five to eight percent annually over the past ten years, far faster than the average wage growth for American workers. As a result, parents and students have continued to accumulate more college debt, while their means for repaying it have waned.

Along with factoring in the soaring cost of higher education, people need to gauge the impact of inflation on their college savings. That puts a premium on saving and investing now in order to grow your school savings at a rate that meets or exceeds the spiraling cost of college.

One of the more effective places to start saving and investing for future college costs is a 529 education savings plan (named after the applicable section of the IRS code). These plans are popular and widely used. Every state offers at least one 529 savings plan, and a total of more than $135 billion is invested in roughly 7 million such plans.

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The CollegeAmerica 529 plan, sponsored by the Commonwealth of Virginia, has the most assets -- about $29 billion in its advisor-sold plan, which contains low-cost investment options offered by American Funds.

The next largest 529 plan by assets is the NY 529 College Savings Plan, with about $11 billion. It offers low-cost investment funds managed by Vanguard.

A 529 savings plan is a simple way to save and invest money for your child's future education. Its key benefits:

  • Money invested grows tax-deferred, as with an IRA
  • Parents own the account, so the child can't control or access it
  • If a child doesn't go to college, parents can roll the account over to another family member
  • Anyone can contribute
  • There are no income limitations to setting up a 529 plan 
  • Most states have no age limit for when the money has to be used

529 savings plans are state-sponsored savings and investment programs. That is, the state sets up the plan with an asset management company of its choice. Individuals open a 529 account with that asset management company according to the state's predetermined plan features.

You are the owner of the account, and the child for whom the account is set up is the beneficiary. Typically you don't deal directly with the state, but rather with the asset management or investment company.

Generally, there are two types of 529s:

Prepaid tuition plans let you prepay tuition at a qualified educational institution at today's tuition rates.

Savings plans let you save and invest money in a tax-deferred account, which can be used to pay for education expenses at any college at a future date.

Despite these differences, the fundamental idea with both plans is that the amount saved today should grow at least as fast, or faster, than the rate of inflation of future education costs.

Possible drawbacks

One concern with 529 plans is what can happen if the money isn't used for college. Funds withdrawn from 529 plans that are not used for education are taxed as income and also incur a 10 percent penalty tax.

But there is an important exception: If you do not use the money in a 529 plan because your child gets a scholarship, then the remainder of the 529 account can be rolled over to another sibling (or relative), or it can be cashed out by the beneficiary with no penalty other than the tax paid (at your rate) on the earnings. The same rule applies in the event of the child's death or disability.

Another concern is how a 529 plan account where your child is a beneficiary will affect her chances of qualifying for financial aid. But since 529 plan accounts are treated as assets of the parent, the assets in these accounts have a lesser impact on the family's expected contribution toward college costs before financial aid is awarded.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.

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