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Saving for college is one of the toughest assignments a parent will ever face. Contrary to what some financial advisors recommend, trying to oversimplify your savings strategy can lead to your missing out on some lucrative opportunities that will boost your children's chances of emerging from college without an insurmountable pile of debt.
Earlier this week, Morningstar announced a new rating system for evaluating college-savings plans, also known as 529 plans. Although these ratings do a good job of steering you in the right direction to take advantage of the tax savings that 529 plans offer, picking a 529 plan shouldn't be the only thing you do to save for your children's college education.
The savings juggling act
Among the many financial obligations people have, saving for their children's college education falls into somewhat of a gray area. On one hand, the amount of money involved is large enough that you can't just expect to cover the full cost out of your paycheck during your child's college years. Instead, most people will have to treat it like any other major savings goal, such as buying a house or saving for retirement, putting aside a little money every month and taking baby steps toward the eventual finish line.
Yet college is also exceedingly difficult to plan for. Costs are constantly increasing, yet if your child gets a scholarship or other lucrative financial aid package, then you may end up having to pay only a fraction of what you expected. Moreover, because many parents face college costs at exactly the same time they're starting to ramp up their savings for their retirement, there are competing interests that can knock your college savings off track.
529 plans try to make college saving easier by acting somewhat like a 401(k) does for retirement saving. The plans allow you to choose from menus of investment options, directing regular monthly contributions toward investments that will hopefully grow sufficiently to meet college expenses.
The best and worst 529 plans
Looking at Morningstar's ratings, the 529 plans that received a coveted Gold rating featured low-cost investments from companies including Vanguard and T. Rowe Price (Nasdaq: TROW ) . Although only four states had Gold-rated plans -- Alaska, Maryland, Utah, and Nevada -- college-savers from around the country can take advantage of those plans. You'll find similar low-cost features among the Silver-rated 529 plans as well, with Vanguard, TIAA-CREF, BlackRock's iShares, and American Funds featured prominently among the plans' investment options.
Conversely, the plans that came up short on Morningstar's ratings tended to have poor performance and high fees. Morningstar criticized Schwab (NYSE: SCHW ) for having costly expense ratios on its investments, while AllianceBernstein also scored poorly with its direct-sold and advisor-sold 529 plans due to poor investment performance.
Adding some spice to your savings
Regardless of how good a plan you choose, the problem with 529 plans is that they restrict your options. You can't invest in individual stocks, and you're stuck with whatever funds a given state chooses to support. The states that top the list arguably have the most flexible, lowest-cost funds, but they're still funds, with all the limitations funds have. Some players, including Wells Fargo (NYSE: WFC ) and Fidelity, have even decided to stop managing 529 plans as pressure on fees has become stronger.
The smart move is to combine 529 plans with other college savings methods. A Coverdell ESA, for instance, lets you invest in individual stocks and other securities, albeit with a very small $2,000 maximum contribution. But with access to mortgage REIT American Capital Agency (Nasdaq: AGNC ) , midstream energy specialist Linn Energy (Nasdaq: LINE ) , and other high-yielding dividend stocks, you can use a Coverdell to get similar tax benefits that 529 plans offer while boosting your portfolio income. Custodial accounts or simply setting money aside in your regular brokerage account gives you maximum flexibility, but you don't get the advantage of tax-free distributions from 529 plans for college expenses. Yet by balancing these different kinds of savings vehicles, you can save in ways that align well with your own resources and goals.
The smart move
As hard as it is to save for college, it's one of the best gifts you can give your kids. By making the most of the savings options available to you, you can ensure that your kids will have the best start possible to their adult lives.
Income-producing stocks are just one idea for long-term goals like college saving. The best investing approach is simply to choose great companies and stick with them for the long term. In our free report on long-term investing, we name stocks that could help you build long-term wealth for retirement, college expenses, or other long-term goals, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.