College costs have been rising for some time now, and there is really no reason to think this trend won't continue. If you have young children, the thought of how expensive college might be when they get there is a scary one. However, there are investment programs you can use now in order to drastically reduce the burden. If you use your time and tax advantages wisely, you might be amazed at what a difference it will make.
I should start planning already? Yes, and here's why...
College is very expensive, and one of the most certain ways to build wealth is to take full advantage of compounding your gains over the longest period of time possible. Current total expenses for four years of college range from just about $92,000 for the average in-state public university to $180,000 for a private institution, and some are much higher. Also, bear in mind this is in 2014 dollars. Who knows how much it will cost when your little ones are ready to go!
When paying for a college education, there are two basic options to consider. You could either start saving money in advance, or you can take out loans to pay for everything. Let's take a look at each situation and consider how much each option will actually cost. For simplicity's sake, let's assume you would like to contribute a total of $100,000 to your child's education whenever he or she is ready to go.
Let's say you want to put off the cost as long as possible. If you were to take out $100,000 in loans to cover your contributions, financed over 20 years it would result in monthly payments of about $715, assuming a 6% interest rate. Over the 20-year period, the total of all of your payments would come to $171,600.
On the other hand, if you average a 7% annual return (pretty conservative), you would only need to set aside $2,950 annually, or just over $245 per month to end up with the same $100,000 after 18 years of compounding. The total of your contributions over 18 years would be just $53,100, or less than one-third of the cost of paying for college after-the-fact.
Why is "tax-advantaged" so important?
The tax advantages of these accounts are so important because of the drastic amount of money it saves you, not only each year, but when the time comes to withdraw the funds as well. Even with the lower long-term capital gains rate, your $100,000 portfolio would be cut down to $85,000, assuming you're in one of the 15% capital gains tax brackets.
Savings plans you can use
There are a couple of ways you can begin saving for your child's future on a tax-advantaged basis, the Coverdell Education Savings Account and the 529 plan. In both plans, your money grows tax-free while invested, and withdrawals are also tax-free as long as the money is used for higher education expenses. However, contributions are not tax-deductible, and may not exceed the amount needed to pay all qualified education expenses for the beneficiary.
A Coverdell account allows the funds to be used for all levels of educational expenses, not just for college. So, if your kids might end up in private high schools, the Coverdell may be the way to go. The other difference is the Coverdell has a much lower contribution limit of just $2,000 per year, meaning it may or may not be enough to cover all necessary expenses.
The best way to invest
Although Coverdell accounts only allow contributions of $2,000 per year, they also offer the freedom to invest in pretty much whatever you want, and this is a much better arrangement than simply picking from a small basket of funds. So, I would suggest maxing out a Coverdell and then contributing to a 529.
For the Coverdell, it is your choice at how active of an investor you want to be. For those who want to do the necessary homework, a basket of high-quality dividend stocks should produce excellent growth and income. If you are a more "hands-off" investor, there is nothing wrong with simply investing your money in index funds and letting it grow tax-free.