Ask TheStreet

Return to Article

Saving for Your Kid's College: Start Here, and Start Now

Jonas Elmerraji

To the question of whether any single stock is a good long-term investment strategy to finance college, the answer is an unequivocal "No."

When you're looking at a long-term, big-budget goal like college, asset allocation rules apply (see "Allocate Your Assets Like a Pro").

If you want to avoid the headache and risk of allocating an education-focused portfolio yourself, taking the hands-off route with a target-date mutual fund (offered by most 529 plans ) is a good way to go.

Here's what you need to know if you're ready to set up a college savings plan for your little Einstein.

Paying for College: It's All About Goals

According to Stuart Ritter, a certified financial planner at T. Rowe Price (TROW Quote - Cramer on TROW - Stock Picks), there are three decisions you need to make when planning for any financial goal: how much to save, what kind of account to use and what investment strategy to follow.

Figuring out what your goals are (and thus how much you need to save) is a very important step in the process. "How much you're going to save has a bigger impact than anything else," says Ritter. "You may nail everything else right, but if you're only putting away $25 a month for your child's college education, you're probably not going to have what you need to fund it all."

How Much

College is becoming a fairly lofty financial goal for many. The College Board projects that four years at a U.S. in-state public college or university will average more than $90,000 a decade from now.

"College tuition is increasing at twice the rate of inflation every year," says Deborah Hohler, spokesperson for Upromise, a college service provider. Both Hohler and Ritter agree that saving far ahead of freshman year is a better move than taking on education debt via loans. Why? It gives students more flexibility in their decisions and frees them from years of college-loan payments.

"About 65% to 70% of all students graduate with [education] debt, and the average student debt today is $20,000. Students who take on debt today will be paying for that debt between 10 and 30 years -- and there's quite a bit of interest they'll be paying," says Hohler. "Starting as early as possible to save for college can make a significant impact for any student."

So how much do you need? That's going to vary drastically depending on things like what school your kid will be going to and what your timeframe is. To get a good handle on a number, head over to the College Board's College Savings Calculator or TheStreet.com's calculator How much do I need to save for college?.

The bottom line: Saving for a child's college education should start as soon as possible, but Ritter warns that it shouldn't take priority over your retirement savings.

The Plan

What kind of account to save in is the second issue that you need to address when planning for a financial goal. There are a number of options out there that can give you some real savings benefits when you're planning for a college education. Here are the ins and outs of each.

529 Plans. "A 529 is an account that gives you certain tax benefits for college savings. The reason you would choose a 529 plan over a taxable account is that you will have more money available to spend on college expenses if you use the 529 plan," says Ritter.

There are two types of 529 plans out there: prepaid plans and savings plans. Prepaid plans let you buy tuition credits at today's rates and use them in the future. Savings plans, on the other hand, let you stash money aside and let it appreciate until the tuition bill comes in. Plans are generally administered by states and managed by investment managers ; because of this, features and regulations usually vary from plan to plan.

One of the trickier things about 529 plans is the fact that their features and fee structures aren't always the easiest to figure out. If you need to get your facts straight, head over to Savingforcollege.com's 529 Plans section, where you'll find a number of 529 plan comparison tools.

Coverdell ESAs. Another option is the Coverdell Education Savings Account (ESA ), which used to be known as the "Education IRA ." Coverdell accounts have income and contribution restrictions ($2,000 maximum contribution per year), but don't have to be used exclusively for college -- a good option for those with pre-college kids in private schools.

Picking which of these accounts to use (or whether you should use both) depends largely on the tax breaks your state will give you for having them. Ritter breaks it down: "If you are saving for college only and the 529 plan in your state gives you a tax benefit, you should start looking at your state's 529 plan. If it doesn't give you a deduction, see if you're eligible for an ESA. If you are eligible, consider the ESA, and put any savings over $2,000 per year in a 529 plan. In some places the benefit isn't that big or the plan has relatively high expenses... there might be other reasons not to choose it, but you should always consider your state's plan first."

Alternatives: Savings Bonds, UGMAs and Roth IRAs

There are other ways to save for a college education that many people turn to every year, such as education savings bonds and Uniform Gifts to Minors Accounts (UGMA). The thing to remember about these is that they shouldn't be your first choice.

Traditionally, savings bonds and UGMAs have been popular because they were the only tax-advantaged options out there. Now specially designed accounts like 529 plans and ESAs are available, and they should be your pick for education savings.

College saving isn't purely the domain of parents, either. Savings bonds might have once been a great way for grandparents to chip in for the grandkids' education, but now it's important to remember that grandma and grandpa (and anyone) can set up a 529 plan with all the tax advantages that come with it.

One of the more attractive elements of the Roth IRA is the fact that you can pay for education expenses without paying any penalties. Even so, that doesn't mean that the Roth IRA is a good savings solution for school. Since contributions to a Roth IRA are limited, using portions for education expenses is a great way to take a huge chunk out of the Roth's income-generating advantages. Just set up a 529 or ESA instead.

Again, no single stock is a good long-term play to totally pay for college. Taking the time to set up an education account for your child is a great way to ensure that they've got all the options in the world when it comes time to look for a college or university. By following the concepts above when you set one up, you'll be on the path to maximizing the bang for your academic buck.