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How-to Guide: Paying for College

At the back of your mind, it lurks, gnawing at you. You can forget about it for a week here or a month there, but inevitably it rises up again to cause you stress and worry. As your infant stands to walk for the first time, it seems comfortably far away. As your child goes to kindergarten on that first autumn day, you can still feel as though you have plenty of time. Yet by the time your teen goes to the prom, it will probably be too late.

At some point, you have to face the big question: How will I pay for my child to go to college?

Don't wait to start saving
Nowhere is the value of compounding returns more evident than in saving for a goal with a fixed time limit, such as financing a college education. If you start early, the amount you have to save to reach your goal will be far less than if you delay implementation of your savings plan until later on.

Even though this makes sense intuitively, it's particularly surprising when you actually look at the math. For these purposes, assume that your investment grows at 10% with monthly compounding in a vehicle not subject to tax and that you have until your child turns 18 to save money for your child's education. If you wait just three years to start saving for your child's education, you will have to save one-and-a-half times as much to end up with the same amount as if you start saving immediately after your child is born. If you wait until your child's eighth birthday, you'll have to save almost three times as much over the remaining 10 years to catch up with someone who saves from the child's birth. And for the true procrastinators who wait until their child starts high school before starting to save, it'll take more than 10 times the monthly savings each and every month during those last four years to make the grade.

As you can see, getting started early can bring huge rewards to disciplined savers. However, there are many different types of accounts for parents to choose from, each offering different benefits and characteristics. Here's a look at some of the most popular vehicles for educational savings.

1. Savings bonds
The federal government has added a number of twists to old-fashioned savings bonds, including one that gives strong tax incentives for their use. Most savings bonds already have a tax advantage; while interest accrues on the bond on a monthly or semiannual basis, the owner of the bond doesn't pay income tax on the interest until he or she cashes the bond in. One added twist is that for certain savings bonds whose proceeds are used for educational purposes, the interest on the bond can escape taxation entirely.

Although savings bonds don't always offer the highest returns available, they do provide a great deal of flexibility. Savings bonds come in amounts as low as $25, and you can buy them without paying any fee. To take full advantage of available options, however, parents and grandparents should also consider other options.

2. Custodial accounts
It sounds simple: Since you're saving for your child, why not set up an account in your child's name? In fact, setting up a so-called custodial account for your child is relatively easy. But there are traps for the unwary, so before you decide to go this route, make sure you know the ins and outs of custodial accounts.

3. Coverdell Education Savings accounts
For those looking for something a little more sophisticated than a custodial account, Coverdell ESAs give you a tax-advantaged option to help you save for educational expenses. The Coverdell has some unique properties, but it doesn't let you save very much -- just $2,000 per year currently. It's worth looking into, but it probably won't be the only tool you'll want to use for saving for college.

4. 529 plans
No college savings strategy is complete without a look at 529 plans. These let parents and grandparents keep control of money they save for kids while giving them investment flexibility and relatively high contribution limits. The hardest thing is choosing from the dozens of available plans -- but here's a quick primer to help you get started.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 23, 2008, at 9:32 PM, cinemodS wrote:

    Warning about EE Bonds purchased for educational use (Tax-free) :

    If your income exceeds $70,000, you will not receive the benefit these bonds were designed for. You will pay the tax.

    Thanks Uncle Sam.

  • Report this Comment On July 23, 2008, at 9:42 PM, cinemodS wrote:

    Correction:

    Warning about EE Bonds purchased for educational use (Tax-free) :

    For single taxpayers, the tax exclusion begins to be reduced with a $63,100 modified adjusted gross income and is eliminated for adjusted gross incomes of $78,100 and above. For married taxpayers filing jointly, the tax exclusion begins to be reduced with a $94,700 modified adjusted gross income and is eliminated for adjusted gross incomes of $124,700 and above. Married couples must file jointly to be eligible for the exclusion.

    Thanks Uncle Sam.

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