Conventional wisdom these days says that parents need to start saving for their children’s college education as soon as those children enter the world. But parents who put off saving until their children are in middle school or beyond shouldn’t worry that they’ve run out of time—it’s never to late to create a college funding strategy.
No matter when you first begin saving, the first step is to decide on your savings or investment plan. Many families are attracted by the various benefits of 529 college savings plans, while others prefer non-specific savings accounts or investment portfolios.
Breaking Down the 529 Plan
State-sponsored college savings plans, commonly known as 529 plans, reward investors with tax-free investment returns, tax-deductible contributions and favorable consideration on financial aid applications. Some states and schools also give the option of locking in the cost of tuition and prepaying as you save.
The price of these benefits is a lack of flexibility. When you use the money in a 529 plan for something other than college expenses, you must pay taxes on the total earnings as well as a 10 percent penalty. If the amount you save ends up being more than you need, your child decides against attending college or you simply need the funds for something else, the benefits of a 529 plan quickly become disadvantages.
However, some of these risks are less of a concern for parents who start saving late in the game. These parents are very unlikely to save more than they need and may also have a much clearer idea of their child’s college plans. Furthermore, they may be in a more stable financial position and less likely to need the money they earn from a 529 plan for an unforeseen expense.
No matter the age of your child, selecting the right 529 plan is key to maximizing your returns. State-sponsored plans are far from uniform, and some charge significantly more in fund management fees and commissions than others do. The good news is that you do not have to invest in your own state’s plan—anyone can invest in any state’s 529 and then use those funds in any state.
In addition to selecting a state, you’ll also need to decide on the type of plan you want. This means choosing a prepaid plan or a savings plan, as well as choosing an investment strategy.
Most 529 programs will offer plans that range from conservative money market funds to more aggressive stock portfolios. It can be tempting to select a relatively aggressive stock portfolio in the hope of higher returns, but this strategy can be risky without many years to ride out market fluctuations. Most experts recommend against aggressive portfolios if your time frame is limited.
Prepaid plans offer significant potential savings and an intriguing decision for the parents of middle schoolers. These savings are contingent upon making a firm college selection and, not surprisingly, many parents of young children are unwilling to lock in this decision so early. Middle schoolers may already know that they want to attend a particular state school; however, the benefits are also less significant since you will only avoid a few years of rising tuition. Parents considering this option should look carefully at whether the tax breaks and investment returns of the savings plan alternative or the locked-in tuition of a prepaid plan is likely to save them more money.
Alternatives to the 529
There are many investment alternatives to 529 plans, which may make more sense for some families. While some of these alternatives are taxable, the greater number of choices means more opportunity to customize the types of investments you make and the amount of money that you invest, and to transfer your investments if you see poor performance. One Morningstar study found that 529 plans frequently fall short of their performance benchmarks, so investors who can pick and choose from a much wider variety of investment options may earn enough to counter the resulting taxes.
Some of the many options include mutual funds, exchange-traded funds (ETFs), dividend-paying stocks, municipal bonds and even individual retirement accounts (IRAs). Municipal bonds in a parent’s name and IRAs are both tax free, and IRA funds can be used for higher education without a 10 percent penalty prior to age 59.5.
Save for College or Save for Retirement?
Not only is it never too late to save for college, but parents of middle schoolers who have not been able to save for retirement may find that they are not as far behind as they thought. Prioritizing retirement savings is critical for several reasons—arguably more critical than saving for college.
To begin with, you or your child can almost always take out a loan to pay for college if you haven’t saved enough money. In contrast, you can’t take out a loan to pay for your retirement. Furthermore, money in IRAs is not taken into account when financial aid applications are considered. Finally, starting early with retirement savings allows you to maximize the amount of money you can receive from your employer in matching contributions.
If you’re the parent of a middle-school aged child and you haven’t started saving for college, there is no reason to panic. But looking carefully at your saving and investing options and coming to a prompt decision will help you to make the most of your money in the time that you have.