College Investing Primer
Creating a strategy for saving for your children's college education isn't quite as easy as ABC, but it's really not all that complicated, either. In fact, sticking to your plan may be the bigger challenge. Here's a three-step approach that might help you get started:
- Take advantage of college savings accounts that offer tax-deferred earnings and permit tax-free withdrawals if you use the money to pay qualified education expenses. These include 529 college savings plans and Coverdell education savings accounts (ESAs).
- Add money to these accounts regularly. In some states, you may qualify for a state income tax deduction for contributions to the state's 529 plan if you're a resident.
- Manage your accounts so that that allocation shifts gradually from growth when the beneficiary of an account is young, to stability as he or she gets closer to enrolling in college or vocational school. Some 529 investment options, called age-based tracks, handle this reallocation.
Investments to Consider
When your children are young, it makes sense to invest primarily in equities, such as stocks and stock mutual funds or exchange-traded funds (ETFs). You can make your own choices in an ESA and select an equity track in a 529 plan. The risk of equity investing, of course, is that growth is not guaranteed. Your account could lose value - potentially all of its value - in a market downturn or if individual investments didn't meet your expectations.
When they enter their teens, you may want to begin switching some of your ESA portfolio into equity income funds, which invest in a combination of dividend-paying stocks and bonds, and intermediate-term Treasury notes. In a 529, you might add a fixed track of fixed-income investments during this period and make your new contributions to this track.
As your child gets closer to college and actually enrolls, you may want to transition to more conservative, interest-paying investments in your account. You can sell some of your equity assets and move the proceeds into CDs. The schedule should be dictated by when your tuition bills will be due, not by what you think the market's going to do.
Investments to be Wary Of
There are a number of investments that don't usually work very well for college savings, because they're too hard to cash in when you most need them, or are too aggressive or not aggressive enough. They include:
- Any investment that doesn't pay enough interest to beat the rate of inflation, including savings accounts, short-term bond funds, money market mutual funds, and similar investments
- Any investments that carry surrender fees that would apply in the period when you'll need to convert the savings to cash
- Any investment that's not easily liquidated, such as real estate, limited partnerships, and some annuities
- Any speculative investments that expose you to greater-than-average risk of losing principal, such as penny stocks and high-yield bonds
Timing it Right
You can sell stocks and stock mutual funds in your ESA at any time, but you can't count on what the price will be when you're ready to sell. That's one of the reasons it can be a good idea to shift gradually from equity investments to bonds and insured products such as CDs to create an account that is less likely to expose you to a potentially sudden loss in value just as you're ready to use the money.
Remember, too, that you can time the maturities of some investments, including CDs and zero-coupon bonds. Since you'll need to pay tuition on a regular schedule, usually in August and January when the new semesters start, that's the schedule to keep in mind as you purchase these products.
In the case of zero-coupon bonds, it's especially important to buy those that will mature during the four- or five-year period that you'll be paying tuition bills. If you have to sell zeros before they mature, you could lose money because these bonds tend to be volatile in the secondary market.
If you're buying US Series EE or Series I Savings Bonds to pay college expenses, remember that you have to keep them at least five years to collect the full interest you're due. As an added bonus, if your income is less than the amount Congress sets for the year in which you withdraw, interest on these savings bonds may be tax free if you use them to pay qualifying college costs. You just have to sure you check out the ownership and other requirements before you buy.