The Best Ways to Pay for Your Child's College Education

Source: Sakeeb Sabakka via Fotopedia.

According to the U.S. Department of Agriculture, raising a child who was born last year until the age of 18 will cost middle-income families an average of $245,000. And for many parents, it won't end there. That quarter-million dollars excludes one more massive expense: college tuition.

Tuition is getting very pricey
In the last 30 years, the cost of average college tuition at public four-year colleges has increased steadily by more than 4% per year. The graph below shows the rise in average college tuition in the the U.S. over the last 30 years, with all numbers adjusted for inflation.

Source: College Board.

This may seem daunting, but parents can prepare for this coming cost using tax-advantaged tuition savings plans and other investment accounts separate from their own retirement accounts.

Let's go over some of the best ways to save for your child's future college education.

1. The 529 plan
A 529 plan is usually sponsored by the state, though it can also be sponsored by a single educational institution. Contributions are placed in investments such as stocks and ETFs and can grow, tax-deferred, over time. When the money is taken out, it incurs little or no income tax. 529 plans generally offer tax deductions on contributions and have no income restrictions, making them a good option for families with higher annual income. They also have exceptionally high contribution limits, so you can invest more toward your child's education and watch the account reap greater returns. Additionally, the custodial fees on 529 plans are low -- usually around 0.25% or 0.3%.

One downfall of the 529 plan is that its uses are limited. If the owners or original contributors take the money out for reasons other than qualifying educational expenses, there will be hefty charges. For example, if your 17-year-old comes home to tell you she's earned a full ride to Harvard, then the options for the 529 account are 1) to use it for college-related expenses other than tuition or 2) to use it for another student's college expenditures. This might be an OK problem to have if you foresee high living expenses for the student (Boston can be expensive) or if you have other kids. Otherwise, if you end up having to pull that cash out or transfer it to another kind of account, you'll pay a fee, just like you would if you pulled money out of an IRA early.

Another limitation of the 529 plan is that, like an employer-sponsored 401(k), it offers a limited menu of investment options. These options may be perfectly viable, but you may be unable to shape the portfolio exactly as you'd like to.

2. The Coverdell Education Savings Account
Similar to a 529 plan, the Coverdell Education Savings Account is another tax-advantaged investment account. As with the 529 plan, the money in the account grows tax-deferred, and when the money is used for qualifying educational expenses, it can typically be withdrawn tax-free. Both plans allow parents to transfer the funds to another student if necessary. Another benefit of the Coverdell is that, much like an IRA, it opens a broad array of stocks, bonds, and ETFs.

However, one disadvantage of the Coverdell plan is that there is usually a lower maximum contribution limit (currently $2,000 per child per year). Furthermore, the annual income of the contributor can effect Coverdell plans, where as it doesn't affect 529 plans. Also, the Coverdell funds must be used for qualifying educational expenses by the time the beneficiary is 30.

3. Do it yourself with your IRA
Using a Roth IRA may be a smart option for families that plan to contribute the $5,500 annual limit or less. While taking funds out of an IRA early usually triggers tax penalties, funds can be withdrawn penalty-free to cover college education-related expenses -- even the expenses of the holder's children and grandchildren. And, of course, any funds left in the account can be saved for retirement and withdrawn for any reason at the age of 59-1/2. Another benefit of an IRA is the freedom to choose your own investments (or have them managed by the particular institution, usually for a fee).

However, most parents won't want to plan to use all or even most of their IRA balance for their children's college, because then they would be depleting their own retirement savings. As your child nears college, you may be nearing your planned retirement. And while there is no limit to the number of IRAs a person can hold (you could have your own and a separate one for your child's tuition planning), your total annual contribution across all IRAs cannot exceed the limit of $5,500.

4. The under-the-mattress option: old-fashioned savings
Don't laugh -- this is a viable option, too, and undoubtedly should be at least a portion of your overall tuition readiness plan. For one thing, it's likely that the money for your child's tuition will need to be ready at a particular time -- say, August of her 18th year. But with the plans above, if the market is down at the time, you may not be comfortable with withdrawing funds and locking in losses. While our investing horizon is long-term, and quite a bit of risk can be tolerated, it would still be nice to have a small cash cushion in case you want to wait a semester or two to deploy the money in your child's savings plans.

Of course, given the rising cost of tuition and inflation, your cash savings will be worth much less in 18 years in terms of how much tuition they will cover. So, as with any smart investment portfolio, a small cash allocation can be appropriate, but it shouldn't be a major part of the plan.

Which plan is right for your future graduate?
Think of this tuition-prep portfolio the same as you would your own retirement portfolio. There may be one option that makes the most sense, but you will likely need a mix of two or three of these options. So consider each option carefully and plan how best to take advantage of those options.