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With the threat of six-figure college costs looming in the future, smart parents get as early a start on saving for their children's education as they can. But rather than looking to a single type of college savings account as the only way to save, you'll do far better taking a broader approach to setting money aside for future educational expenses.
Going through the choices
Over the past month, I've written a lot about how 529 college savings plan are a vital ingredient of a successful investing plan for parents aiming to pay all or part of their children's college costs. With significant tax breaks that include tax-free income on the money you use to pay for college, 529 plans offer unparalleled benefits to parents. With dozens of plans offering a wide variety of mutual funds and ETFs, you can generally find investments that will help you create a core portfolio for your college saving.
But 529 plans aren't perfect. Investment limitations and high costs for some plans have made some college savers question whether 529 plans are really worth the hassle. Rather than giving up on 529 plans entirely, though, the better answer is to incorporate alternatives with a good 529 plan to create the best overall saving strategy.
Understanding the alternatives
Parents have two reasonable choices beyond 529 plans to save for college. The first is the Coverdell Education Savings Account or ESA. If 529 plans are like employer-sponsored 401(k) retirement plan accounts, then Coverdell ESAs are like IRAs. Unlike 529 plans, Coverdell ESAs have almost no restrictions on what investments you can make. You can open a Coverdell ESA with most brokers, giving you the full range of stocks, bonds, funds, and even some more exotic investments. And like 529 plans, the income from Coverdell ESAs is tax-free when you use it for educational expenses.
The other option is to set up a custodial account. Differences in state law make the rules for custodial accounts slightly different from place to place, but the general idea is that you can open an account in a child's name and manage that money in whatever investments you see fit.
Both of these alternatives have enough drawbacks, however, that you wouldn't want to use them as your sole college savings vehicles. Coverdell ESAs currently have a yearly contribution limit of just $2,000, and unless Congress acts, that limit will fall to just $500 in 2011. With custodial accounts, you're legally obligated to turn the money in the account over to your child at the age of majority, which is typically 21. Financial aid treats custodial accounts as available for the child's contribution to educational expenses, which can lower the amount of outside support your child receives. There's also no tax deferral for investments in a custodial account, although your child's lower tax rate may apply for part of the income the account generates.
A healthy mix
With all those pros and cons in mind, here's a three-part approach toward building a well-balanced college savings strategy:
- Use low-cost 529 plans for core assets. Plans that offer index funds or ETFs are the easiest way to implement a solid asset allocation strategy based on your child's age and your investing temperament.
- With the limited contributions allowed for a Coverdell ESA, invest in high-risk, high-reward individual stocks. For instance, fellow Fool Jordan DiPietro recently highlighted real estate investment trust RAIT Financial (NYSE: RAS ) and Chinese online jeweler Fuqi International (Nasdaq: FUQI ) as good candidates to rise strongly from recent selling pressure. A similar high-risk play is Crown Media (Nasdaq: CRWN ) , which Jim Royal called out as a potential takeover candidate.
- If you're comfortable using a custodial account, use it to take advantage of your child's favorable low tax rates. For instance, even with modest amounts in a custodial account, high-yield dividend plays Anworth Mortgage Asset (NYSE: ANH ) , MFA Financial (NYSE: MFA ) , and Linn Energy (Nasdaq: LINE ) can generate enough income to generate the $950 in investment income a child can earn tax-free. If you're more conservative, look into the dividend ETF SPDR S&P Dividend (NYSE: SDY ) , which invests in stocks with long histories of making payouts to investors.
529 plans are a great way to save for college, but they aren't the only answer. By using custodial accounts and Coverdell ESAs as supplements to a 529 plan, you can get the best of all worlds. That's something your kids will thank you for -- eventually.
Stay tuned as Dan wraps up his series on saving and paying for college next Wednesday.