How to Save $22,000 Without Trying

I have a soft spot for student loan provider Sallie Mae (NYSE:SLM). Not really, but I do have a long-standing relationship with the company. In the eight years that it's been receiving my monthly payments, my financial life has undergone numerous changes: a home purchase, a mortgage refinancing, a 401(k) rollover, different auto loan lenders, transferred credit card balances, to name a few.

In fact, with all the consolidation in the industry, even my bank has changed hands several times. Amid all those changes, though, there has always been one constant -- an entry in my checkbook around the middle of the month for a student loan payment. Well, plus my wife's student loan, I am now saddled with two entries every month. Combined, the disbursements remove $207.68 per month (or nearly $2,500 per year) from my checking account. I can think of more than a few places where that money would have been better spent.

Fortunately, both my wife and I were lucky enough to receive full-paid academic scholarships to our respective universities; otherwise, those payments might have ended up totaling some serious money.

Start saving your pennies now
In less than a month, we are expecting our second child, and as the days tick down we still can't agree on a first name, a middle name, or even how to decorate his room. There's one thing we are in complete agreement on, though: the immediate establishment of a college funding plan.

We've all seen the sobering statistics on soaring tuition prices, which have been outpacing the general rate of inflation by about a two-to-one margin over the past few decades. According to the College Board, tuition (not including room, books, pizza, etc.) costs jumped 10% last year to reach $5,132 annually -- and that's just for a public school.

Fortunately, Uncle Sam has designed several tax-advantaged college funding vehicles to aid in the savings process. If you don't know a 529 plan from a cafeteria plan, you may want to read an overview in the Fool's comprehensive College Savings Center.

Without getting into the specifics (fellow Fool Robert Brokamp has done a good job of that), suffice it to say that individual circumstances should dictate which account is appropriate. Personally, I tend to prefer the flexibility of the Coverdell Education Savings Account -- where proceeds can be invested in stocks, bonds, mutual funds, and other investments of my choosing. Fortunately, both allow tax-free withdrawals for qualified higher-education expenses such as room, board, and tuition -- sorry, no mention of keg parties.

A modest contribution of only $100 per month would go a long way toward reaching my goal, growing to almost $50,000 (assuming an 8% return) by the time my as-yet-unnamed son is ready to enroll. For the sake of argument, though, let's assume I don't have an extra $100 per month lying around, and that any cash surplus is generally used by my wife for new shoes (hypothetically speaking, of course).

Let dividends do the heavy lifting
For anyone interested in reducing their out-of-pocket expenses -- or simply augmenting their current savings plan -- why not turn to your portfolio instead of your checkbook? By that, I mean let the companies you already own help jump-start your college savings plan. Reinvesting dividends is a great way to build wealth, but no one ever said you had to reinvest them back into the companies that issued them. Here's an easy three-step plan:

1. Assemble a portfolio of solid, dividend-paying companies in an ordinary brokerage account.
2. Sweep all dividend payments into a money market account, with explicit instructions to electronically transfer the entire balance once per quarter to a Coverdell ESA (most brokerages will accommodate this type of request).
3. Cross-reinvest the proceeds in a portfolio of carefully selected mutual funds.

Of course, for this type of plan to work effectively, it helps to target companies that offer attractive, reliable, and rising dividend payments. To illustrate the strategy, I have chosen to hypothetically invest $10,000 equally among the following five companies: ConAgra (NYSE:CAG), General Electric (NYSE:GE), Bank of America (NYSE:BAC), Coca-Cola (NYSE:KO), and Procter & Gamble (NYSE:PG).

Each is a member of the new S&P Dividend Aristocrats index. For induction, a company must have not only distributed a regular dividend for the past 25 years but also increased its payment every year along the way. Not surprisingly, most of the companies listed tend to be blue-chip leaders that are attractive investments in their own right -- aside from the generous dividends they offer.

For calculation purposes, I assumed that dividends would continue to rise over the next five years at the same rate as the previous five. From there, I leveled off all future increases to a flat 6% growth rate. If any of these companies happens to boost its payout at a faster clip, even better, but I'm not willing to bank on it. Here's what happens:

As the chart illustrates, the annual dividend stream will rise to $478.06 by the fifth year and a hefty $1,019.65 by the time college applications are due. At the end of the 18-year time frame, a grand total of $11,585.17 would have been dished out by my five benefactors.

Do even better
Of course, the proud parents who have little doubt that Junior is destined to one day walk the halls of Harvard will likely discover that this amount falls short of the target. For those in search of even higher yields for this strategy, consider a portfolio filled with companies profiled in the pages of Motley Fool Income Investor. Since lead analyst Mathew Emmert started the service in September 2003, his selections have generated a market-beating 18% total return and currently offer a juicy average dividend yield exceeding 4.4% -- a full point above the five chosen above.

Regardless of which companies are chosen, all those quarterly payments aren't just going to sit idle during those years collecting dust in the Coverdell ESA. You can reinvest them in any manner you see fit, although I'd recommend mutual funds or possibly more dividend payers since the Coverdell should be one of your more conservative accounts.

But if the total dividends reinvested can earn a compounded annual return of 8.5% -- or two percentage points below the total historical return of the overall market -- they can grow to almost $22,000 tax-free for Junior's college simply by redirecting the dividends from your own savings.

Foolish final thoughts
The key is to get started as soon as possible, which in the case of the Coverdell ESA means starting as soon as the beneficiary is born. And if you want more hints about the kind of dividend payers that can make this experiment a reality, consider a 30-day free trial to Motley Fool Income Investor. As I said before, Mathew finds two companies every month that offer market-beating yield and capital gains opportunities.

Oh, and if you know of a good baby name, please let me know.

Fool contributor Nathan Slaughter owns shares of Bank of America. The Fool has a disclosure policy.