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 like you have plenty of time. Yet by the time your teen goes to 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 birth. And for the true procrastinators who wait until their child starts high school before starting to save, it'll take over 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.
Everyone learns about money and savings in different ways. For some people, the first exposure they get to the idea of saving and investing is from their grandparents. Enclosed with a birthday card is a piece of paper that says "United States Savings Bond" on it. When asked about it, the grandparents explain that the savings bond earns interest over time and will eventually be worth far more than what they paid for it. They suggest putting the savings bond away in a safe place, such as a bank safe deposit box, and keeping it until it's needed to help with school or in an emergency.
For many children in this scenario, the gift is a bit disappointing. After all, what fun is money you can't touch for years? However, as a teaching tool, the bond has a lot more value than its investment return.
More recently, 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 semi-annual basis, the owner of the bond doesn't pay income tax on the interest until the owner chooses to cash in the bond. 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.
The confusing thing about this provision, called the education tax exclusion, is that it doesn't apply to savings bonds owned by children. In order to claim the exemption, the owner of the bond has to be at least 24 years old at the time the bond is purchased. At first glance, this seems to be almost worthless, since the number of people who spend money on education for themselves after age 24 is fairly small. Because the exclusion is available for expenses paid on behalf of a dependent, however, it can apply in a much wider range of circumstances. What this means for practical purposes is that if you want to use savings bonds to assist you with education expenses, you should generally hold them in the name of the parents or grandparents rather than in the name of the child.
There are a number of other rules governing the savings bond education tax exclusion. The exclusion is only available to those taxpayers whose gross income is below a certain limit ($94,700 for married couples and $63,100 for singles, in 2006). Also, the full exclusion is only available if the total proceeds of the redeemed bonds, including principal, are used for eligible educational purposes. So if you paid $10,000 for bonds and redeem them for $11,000, the $1,000 of interest can only be fully excluded if you incur at least $11,000 in education-related expenses. Both Series EE and Series I bonds are eligible for the exclusion, but only bonds issued in 1990 and after qualify.
One interesting thing is that the definition of eligible educational expenses includes funding a qualified state tuition program, also known as a 529 plan. Therefore, one could theoretically cash in savings bonds, deposit the proceeds into a 529 plan, and exclude the accrued interest on the bonds.
While savings bonds do not always offer the highest returns available, they 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 that will be discussed in the next part of this article.
For more articles in this series:
- Get Your Kids to College: Coverdell ESAs
- Get Your Kids to College: Custodial Accounts
- Get Your Kids to College: 529 Plans
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