Exploring College Savings Plans

From the moment a baby is born (and sometimes from even earlier on), the parents begin concerning themselves with how to save enough money for that kid's eventual college education. Thankfully, colleges, universities, and the local, state, and federal governments have come up with a variety of programs designed to help and encourage parents to sock money away in stable growth investment vehicles for that (inevitable?) day when young Miss or Mister steps out onto campus a doe-eyed, first-day freshman.

You may have heard of many of the more common programs, including: Coverdell accounts, 529s, Roth IRAs and prepaid or guaranteed tuition. That's the "help." The "encouragement" comes in the form of financial benefits, like tax breaks, tax deferments, limitless investing options, self-directed investing, and a notable absence of penalties. The difficulties arise when it becomes clear that none of the typical college savings plans incorporate all of the savings benefits.

So which plan do you choose? Which benefits would do you the best good? The second question is probably better answered first. To give you a clearer idea of which college savings plan or plans would best suit you, let's examine the benefits and limitations of the most common options.

The problem with 529 accounts and other university-based or state-based plans is that a penalty is imposed should the child not attend a specific university or a university in a specific state. Setting up a plan like this early on in a child's life - which is the only way to really make a program like this pay off - without knowing a child's interests and aptitudes could be a difficult challenge. What if, for example, your child develops a gifted skill in a particular area that requires his or her education be out of state? That money you saved in a state plan does you little good now.

The other hitch with state and university-based plans are the penalties imposed if your money is not spent on "qualified" expenses. What qualifies as an acceptable college expense is different for each plan, so you'll want some degree of certainty that you'll be spending the money you're saving on expenses that do indeed qualify.

The greatest drawback to these types of plans, however, is the fact that they are free to change the rules whenever they like. Just because you may already be participating in such a plan doesn't mean you and "they" are locked in to the terms you understood and agreed to when you made your first deposit. In fact, in doing so, you probably even signed a document attesting that you were aware they may change the rules on you with minimal notice.

In summary on the university- and state-based plans - they offer too many opportunities for a participating parent to fail and not enough opportunity for them to succeed (or at least not enough peace of mind for them to proceed with confidence). Tuition could rise much faster than predicted and you could wind up short. Or tuition could rise less than expected and you could have ended up sacrificing more than it turns out you needed to.

If your savings plan forces you to invest your money in the stock market, the situation is even riskier. As your financial advisor will profess, it does depend a bit on your time horizon. Over any 15-year period since its inception, the stock market has outpaced all other investment vehicles. But in any given year, there could be a crash so damaging that if it happened during a year your child was planning on going to school, you wouldn't be able to afford it. And remember, government promises to cover tuition fully in case of such events have been broken before and therefore can't be trusted.

Speaking of compulsory investing, many state-based programs limit your options as to where you can put your money to a select number of mutual funds, usually those that are run by the very brokerage house handling your savings account. How convenient - for them. A bit of research shows that most of these funds come with higher fees and a track record of lower returns. The brokerage firms consider most of these college savings accounts to be small potatoes, and therefore want to invest as little of their own resources into such accounts as possible. Thus they set up restrictions that support minimal trading and minimal client-broker interaction.

A better option are federal college savings plans because they give you a far superior option of investment vehicles - these include educational Roth IRAs and other education-related savings accounts. Also, money saved in these federal programs can be applied to any accredited university, anywhere in the country. In most cases, your money grows tax free and your withdrawals are exempt from federal and some state taxes.

Quite possibly your best bet for college savings - provided you start before your child reaches the age of 12 - is to go with iBonds issued by the U.S. government via TreasuryDirect.gov. They offer you the greatest control and flexibility over your money. They don't demand all the paperwork or hold you hostage to a litany of rules and restrictions like many of the other savings options do. They give you a respectable rate of return, with the principal being inflation adjusted quarterly. There are no brokerage fees and any income taxes on earnings are deferred. When an accredited university withdraws this money for your child's education, it is a tax-free redemption. 

There are a few exceptions to this proclaimed lack of rules and restrictions, however. You can't withdraw anything in year one after purchasing the iBond, and if you withdraw funds within the first 5 years you are assessed a penalty equivalent to three month's interest.

iBonds are often neglected when parents consider college savings options because they are not thought of as "college investment vehicles." This is because money saved and earned in such a way can be used for anything you wish - college or otherwise.

You may find that your circumstances call for you to get multiple accounts. In this case, be sure none of the accounts you open have rules prohibiting your use of these vehicles should your income exceed a particular threshold.

In closing, when evaluating college savings plans, look for a variety of investing options with the fewest penalties, the fewest restrictions, tax breaks or tax deferments, and the ability to maintain total control over your savings.

Kenneth C. Kelly is the President of Strativia, a financial management software development and services company specializing in applications for personal and business use.  Strativia is the developer of Budget Forecaster, a sophisticated home budget and personal finance management software package.  Website: www.strativia.com. Contact: info@strativia.com.

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