How to Save for College

With college costs always on the rise and the economic downturn still a concern, you may be wondering how you're going to help your child with his or her future college expenses. In this column, "Early Show" financial guru Ray Martin gives advice on building a reliable college fund for your child.

It's no surprise that another consequence of the economic downturn and recession is that parents are saving less for their children's future college expenses. According to "How America Saves for College," an annual study by Sallie Mae, a leading student lender, parent's confidence in their ability to save for college has sharply declined over the past year. Parents who said they are not very confident that they will reach their college savings goals jumped to 44 percent, up from 31 percent last year. One third said they are saving less this year than last and 15 percent said they have saved nothing at all during the past year.

According to the study, families are saving an average of $2,676 for college annually, or 3.6 percent of their annual income. But the study estimates parents need to save 5.7 percent of their income annually to meet their savings goal by the time their child goes to college. How do folks think they will get the money to pay for their child's college costs? Nearly half (47 percent) of parents surveyed said they expect to use student loans to pay for college, up from 37 percent last year. But that's not necessarily a viable option given the difficulties and limitations of student loans these days.

But one bright spot remains: Among those who are saving for their child's future college costs, they feel more confident in the fact that they have a plan to save. Some also report using supplemental funding sources and rewards programs (such as UPromise) to increase college savings. Clearly saving for college is a more viable strategy for parents with younger children who are years away from college and of the parents with children 7 and under who are saving for college costs, 43 percent are using 529 plans.

529 Plan - How it Works:
529 savings plans are state-sponsored savings and investment programs. The state sets up the plan with an asset management company of its choice, and you open a 529 account with that asset management company according to the state's predetermined plan features. Typically, the parent is the owner of the account, and the child is the beneficiary. Typically, you don't deal directly with the state, but rather with the asset management/investment company that provides the funds and customer services for the plan.

The benefits of 529 Plans include:
• The account owner does not pay income taxes on the account's earnings.
• The owner/parent always has control of the account - not the beneficiary/child.
• If the beneficiary/child doesn't go to college, the account can be transferred to another family member.
• Anyone can contribute to the account.
• There are no income limitations that might make someone ineligible for an account.
• Most states have no age limit for when the money has to be used.
• If the child gets a scholarship, any unused money can be withdrawn without paying any penalty (the owner will include as taxable income the earning taken out of the 529 plan account).

Of course, the big advantages to 529 plans are the tax benefits, which typically fall into two categories: Federal and State income tax benefits. While invested, the earnings on money in 529 plans grow tax-deferred and withdrawals are FREE from federal income tax, as long as withdrawals are used for qualified higher education expenses (QHEE) of eligible education institutions.

Generally QHEE includes expenses for any accredited degree-granting educational institution, whether it is public, private, two-year, or four-year. Even some international schools qualify. In most states, qualified education costs include tuition, fees, books, supplies, room, board, transportation, and even computers when one is required by the school.

In 2006, the Congress approved a 529 tax permanency provision, removing the uncertainty surrounding the tax treatment of 529 plans and provides college savers using 529 plans with unique tax benefits going forward. The Pension Act does not help Coverdell education savings accounts, which will still face a 2010 sunset of tax benefits contained in EGTRRA. This gives 529 Plan the edge over Coverdell accounts.

As for state tax benefits, about 32 states offer some tax benefits such as an above-the-line deduction from income or a tax credit for all or a portion of the contributions of those who contribute to their own state sponsored 529 saving plan.

New Flexibility in 2009:
529 plan account owners will be able to make two investment change requests per 529 account during calendar year 2009. Current rules contain a once-per-calendar year investment change restriction. According to the IRS, the increased flexibility is being granted "in response to concerns that have been caused by the recent condition of the financial markets." The change is applicable to calendar year 2009 only.

Planning Tip: Folks with money invested in 529 plans should review their plans performance and any newly available investment funds recently added to their plan and make changes/update the allocation of their investment mix now, if need be.

Use a Roth IRA or a 529 Plan to save for college expenses?
A popular question is whether it is better to use a Roth IRA instead of a 529 Plan to save for future college costs. In order to be eligible to contribute to a Roth IRA, you must have earned income equal to or more than the amount of the contribution. Dividends and interest income don't count as earned income. Many children do have jobs and can open and contribute to a Roth IRA, but this is not likely for younger children.

Even if a child does qualify to contribute to a Roth IRA, it makes for a much better retirement vehicle than it does a college-savings vehicle. Earnings on a Roth can be distributed tax-free after the account owner reaches age 59 1/2 and satisfies a five-year requirement. But earnings that come out before age 59 1/2 are taxable even when used for college expenses. (The 10-percent early distribution penalty may be waived under the special exception for higher-education expenses.)

Of course, one good thing about a Roth IRA is that your contributions come out before the earnings do. In addition, the contributions portion can be used for any purpose, including education, without tax or penalty.

The surprise for many parents, however, is the potential financial-aid penalty: The entire IRA distribution, taxable or not, must be included in base-year income on the student's federal financial-aid application for the following year. This can dramatically reduce a need-based aid package.

For these reasons, it's recommended to use a 529 plan to save for future college expenses. Contrary to popular belief, 529s are not necessarily laden with a lot of costs. In fact, the expenses associated with 529 plans have dropped significantly over the past few years.

Finding the Right 529 Plan for You
With over 80 available, it can be a daunting task to find a 529 savings plan that is right for you. Here are some things to look for:

• Check out your own states plan first: Check to see if your state offers a plan and allows for state income tax benefits for contributions to its own plan. Also, inquire as to any other benefits offered by your state such as a state tax exemption for earnings used for college and exclusion of 529 accounts from consideration for state funded financial aid programs.
• Look for the best investment performance: Don't lose sight of the big idea -- you are saving and investing money for future college costs. This means that when choosing a 529 investment choices and performance matters. Because your investment objective will change from growth (when the child is many years from college) to preservation (when they are nearing college years), look for a plan with a wide range of investment funds with better-than-average performance. Check out the Top Ten Performing 529 Plans as ranked by SavingforCollege.com. Also check out the investment ratings for your 529 Plan at Morningstar.com.
• Go for Lower Fees and Expenses: All things being equal, if you select a well run 529 plan with low costs and fees, junior will have more money for college. So look for a 529 plan with very low fund fees and expenses. More than a dozen states have cut their 529 plan fees in one way or another over the past year. Many states offer two classes of the very same 529 plan: a direct-sold and a broker-sold option. You can guess which option costs more and which costs less. 529 plan savers can search on Savingforcollege.com to find the direct-sold 529 plan option for their state, where investment expenses may be lower and no sales loads will apply.

Two 529 Plans that seem to rate well by the above criteria include the Utah Educational Savings Plan Trust which offers Vanguard funds, the states fixed income fund and an FDIC insured savings account and the New York 529 College Savings Program, with five age-based portfolios, nine individuals funds and a short-term reserves fund all managed by Vanguard, and can be linked to the UPromise rewards program to increase your savings faster. Both of these highly rated 529 Plans allow nonresidents to open and contribute to these plans.