How to save for your kid's college

June 2, 2010 - PRLog -- Many parents who invested in 529 college savings plans got a nasty shock in 2008, when some supposedly conservative plans plunged by 30% or more. Instead of preserving money that was about to be used for college expenses, these plans erased it.

State-run college savings programs are still a good option for many families. But the 2008 debacle highlighted the importance of picking the right savings strategy, monitoring it closely and taking an active role in your investments as college draws near.

The reality is that no single college savings method works well for every family. The right way for you, personally, to save for college depends on several factors, including:

•Your tax bracket.

•Your child's age.

•How much control you want over your investments.

•How much financial aid you expect.

Many people don't realize that financial aid is based largely on income -- primarily that of the parents, but also that of the student.

(Assets matter, too: The typical college will want the student to spend 20% of his or her savings annually on college costs, while the parent is expected to pony up 5.6% of certain assets each year.)

Keep your expectations realistic :

The best way to figure out how to save for college is to use your income, and your tax rate, as a guide. Before we get into a bracket-by-bracket rundown, though, there are a few caveats you should understand:

Caveat No. 1: The following breakdowns assume that your child is relatively young. If you've got five years or fewer until your first tuition bill comes due, you may want to skip the tax-deferred options, said Kathy Kristof, the author of "Taming the Tuition Tiger: Getting the Money to Graduate."

That's because you don't have enough time to earn much in the way of investment returns, so tax breaks on earnings are of little benefit. Saving in taxable accounts will give you more freedom, because you won't have to deal with the restrictions that come with tax-deferred accounts.

Caveat No. 2: Loans make up more than half of financial aid packages. So even if your savings reduce your ability to get financial aid for your child later, don't sweat it too much; you're simply sparing him or her future debt.

Caveat No. 3: These strategies assume the tax laws will remain pretty much the same until your kids are grown. That's a pretty big if. Should Congress make major changes, you'll need to revisit your strategies.

The lowest brackets
This includes folks in the 10% and 15% brackets, which in 2009 are those with taxable incomes up to:

•$33,950 for single filers.

•$45,500 for heads of household.

•$67,900 for those who are married filing jointly.

If you're in the lowest brackets, you don't benefit all that much from tax-deferred accounts because you don't pay very much income tax to start with. You also probably won't be able to save the huge amounts that might make tax deferral a better deal.

But you do have the best shot at getting significant financial aid. So your guiding principle should be to save in ways that don't mess with your child's ability to earn scholarships and grants later. Here are some do's and don'ts for your tax bracket:

Keep your savings in your own name. Parental assets weigh less heavily in financial aid calculations. Plus, you have the flexibility to use the money any way you want.

Consider beefing up your home equity or retirement savings. Most colleges don't count these assets at all. If your child makes it into an elite private school that does, you'll still be expected to spend only a small portion of these savings on his education.

Think twice about Coverdells or 529 plans. These plans allow you to set aside money that can grow tax-deferred and that's entirely tax-free if used for qualified education expenses. You can contribute $2,000 a year to a Coverdell; in contrast, 529 plans typically have much higher limits (more than $300,000 in many states). The tax benefits for both make them a pretty great deal for higher-income parents, but they have some potential drawbacks:

•You can't claim the valuable American Opportunity or Lifetime Learning tax credit for school expenses you pay with Coverdell or 529 plan funds. (These credits aren't available to singles and heads of household with adjusted gross incomes of more than $80,000 or marrieds with AGIs over $160,000.)

•If you don't end up spending the money on qualified college expenses, you'll face taxes and penalties. Coverdells (formerly known as Education IRAs) must be spent by the time the beneficiary reaches age 30, or the tax consequences kick in. There's more flexibility in state-run 529 plans, where funds can be shifted to another child's account or even used by the account owner for qualified education expenses. Still, if you don't use the money for school or need to withdraw it for other expenses, you'll face income taxes and 10% federal penalties.

•Your ability to change your 529 investment mix is limited. Typically you can change your allocation just once a year in the state-run plans.

The good news is that Coverdells and 529s don't have a big impact on your ability to get financial aid, says 529 guru Joseph Hurley, a CPA who runs Savingforcollege.com. The money typically is treated as the parents' asset, and distributions aren't counted as either the student's or the parents' income as long as the cash is used for qualified education expenses.

Don't invest in custodial accounts. Custodial accounts include UTMAs (Uniform Transfers to Minors Act) or UGMAs (Uniform Gifts to Minors Act). Colleges consider these accounts to be the students' assets, which will count heavily against them when financial aid packages are calculated.

What if you already started saving in custodials? All is not lost. If you spend down your custodial account money before your child is a junior in high school, the money won't count against him or her. (Custodial account money can be spent on anything that benefits your child, from camp to a computer to a car; just don't use it on stuff you're required as a parent to supply anyway, like food, clothes or shelter.)

Spend down the account, though, only if you would have incurred these expenses anyway and can put an amount equal to what you've spent into savings in your own name. As Kristof notes, you don't want to throw away a dollar in savings just because you might lose 35 cents in future financial aid. By Liz Pulliam Weston, MSN Money.

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