This is a post from staff writer Robert Brokamp of The Motley Fool. Robert is a Certified Financial Planner and the adviser for The Motley Fool’s Rule Your Retirement service.
Here’s an idea: Leave juvenile delinquents in a prison for three hours to be harangued by hardened criminals in an attempt to convince the kids to change their ways.
That was the premise of the 1978 documentary “Scared Straight!” which won an Oscar and an Emmy. When it aired on TV, it was the first time some networks had allowed some very dirty words that you’d never hear from Mork or Mindy.
Many correctional systems across the country tried their own versions. Unfortunately, studies indicated that all the cursing and yelling and in-your-facing didn’t have a positive effect (in fact, it may have backfired).
But that didn’t stop “The Daily Show” from trying its own version — except instead of trying to save teenagers from a life of crime, this was an attempt to save them from student loans.
The episode began with a nice fellow by the name of T.J. lecturing to seven high school kids in a classroom. T.J. has an illustration degree and $170,000 of debt. “I screwed my life up going to college,” he tells the kids. “I’ll be dead before these loans are paid off. Don’t make the same mistakes I did.” Unfortunately, T.J.’s reasoned approach didn’t get through to the kids, so correspondent Aasif Mandvi brought in two fellows who looked more like the people in the original “Scared Straight!” They took a more aggressive tone and used different language, such as “Student loans are like herpes with compound interest!”
Longtime readers may recall that I think college is a big, fat, hairy rip-off, and that universities are at least somewhat immoral. But the truth is that I suspect my kids will go to college, and that my wife and I are saving for that expensive day. While a degree might enhance a graduate’s financial situation, the chances are increased by getting a debt-free diploma. However, there are only three ways to manage that: (1) build up plenty of before college; (2) get the most free financial aid (i.e., scholarships) possible; or (3) pay for college out of current cash flow.
In this article, we’ll cover Option 1. For Option 2, read 15 Things You Need to Know About Financial Aid. As for Option 3, we’ll point you to a tool that will help you calculate how much college will cost you, so you know whether you can pay for it out of pocket.
That tool is the savings calculator at Savingforcollege.com. It estimates the total cost of college based on your child’s age and tells you how much you need to save each month to reach that goal. The calculator has plenty of flexibility that allows users to fiddle with the assumptions, and it can even help look up the costs of specific colleges.
Now that you know how much college may cost you — and you’ve recovered from your fainting spell — let’s discuss how to save for that big chunk of higher-education change.
Where to stash your college cash
You can save for college in a variety of accounts, but there are three main candidates: the Coverdell Education Savings Account, the 529 prepaid plan, and the 529 savings plan.
Each option has the benefit of tax-free growth as long as the money is used for qualified higher-education expenses (otherwise, the earnings will be taxed and penalized 10%). Also, the assets can be transferred to other family members if the beneficiary doesn’t need the money (whether because of scholarships or mishaps). As for their differences: Pull up a desk, sit up straight, and keep your eyes on the chalkboard.
Coverdell ESA
What it is: An investment account that is opened with a brokerage or mutual fund company, owned by either the parents or the student.
Limits: Up to $2,000 can be contributed annually. Contributions are phased out at incomes between $95,000 and $110,000 for single tax filers, $190,000 to $220,000 for married filers (though there are some ways around these limits). Contributions can be made until the student turns 18 and must be withdrawn by age 30.
Investment choices: Whatever is offered by the company with which you’ve opened the account.
Impact on financial aid: Depends on the account owner. Assets owned by a student have a greater negative impact on aid eligibility than assets owned by the parents, though this impact is lessened if the student is still a dependent of the parents.
Why choose the Coverdell: If you want maximum control over your investments in terms of what you can buy and how often you transact, this is the education savings account for you. Also, unlike with 529 plans, Coverdell assets can be used for elementary- and high-school expenses. However, given the low contribution limits, saving only in a Coverdell will likely not be enough.
529 prepaid plan
What it is: An account offered by some states that locks in tomorrow’s tuition at approximately today’s prices (or at a small premium). The lock on tuition applies only at in-state schools; the funds in the account can be used at a private or out-of-state school, but with no guarantees that they’ll cover the entire cost of tuition.
A consortium of private schools also offer their own prepaid plan, which provides guarantees for students who attend any one of the 270 participating universities. Only 16 states offer prepaid plans, and some have closed their plans to new investors. Low investment returns and budget reductions are causing some experts to question whether all states can fulfill their promises to participants in prepaid plans.
Limits: The contribution amounts are set the by states, based on factors including expected tuition growth and investment returns. Participants can only contribute at certain times of the year. Many plans prohibit students already in high school from opening a new account.
Investment choices: None — all the money is managed by the states. The “rate of return” is essentially the future growth of tuition.
Impact on financial aid: The plan is considered an asset of the parent as long as the student is a dependent.
Why choose a prepaid plan: If you live in a state that offers a plan (or choose to participate in the private colleges’ consortium), you want to lock in today’s costs, and you’re reasonably sure your student(s) will attend a participating school, a prepaid plan may be for you.
Prepaid plans are also attractive to those who would prefer their funds to be managed by the state, rather than self-managed and subject to the whims of the markets. As mentioned, though, some states may not be financially capable of fulfilling their obligations to participants in prepaid plans. Finally, most of these plans just cover tuition; you’ll have to choose another account to save for other expenses, such as room and board.
529 college savings plan
What it is: An account sponsored by states but administered by financial-services firms. Families are not required to choose their own state’s plan — which is good, given that not every state has one — but some states do offer tax breaks to citizens who choose the in-state plan.
Limits: Very high contribution limits (more than $200,000, on average), and no income restrictions.
Investment choices: A selection of mutual funds, including age-based portfolios, which are allocated among various asset classes and gradually get more conservative as the student nears college age. Generally, investment selections can be changed just once a year.
Impact on financial aid: The account is considered an asset of the parent (or grandparent), which has a lower impact on financial aid.
Why choose a 529 savings plan: You can contribute more than $2,000, you want to save for college costs beyond tuition, you value the tax deduction offered by your state (if applicable), and you don’t mind the limited investment choices.
Now what?
The good news is you don’t have to choose just one of these accounts. You can contribute to each, if you have the resources and it makes sense for your situation. For example, you might participate in a prepaid plan to manage the future costs of tuition, then max out the Coverdell (because you enjoy picking individual stocks, an investment choice not available in 529 plans) to help cover room and board, and contribute to a 529 savings plan for additional savings. Of course, such a strategy would require a lot of cash; for those seeking a place to contribute a few hundred dollars a month, the 529 savings plan is the most popular choice.
If you go that route, start by investigating the plan your state sells directly to residents (as opposed to those sold through financial advisors). If there are tax benefits from going with the home team, you may need look no further. That said, it’s not worth choosing a horrible plan just for the potential tax benefits. Savingforcollege.com is an excellent place to begin your research — it provides a review of the tax benefits each plan offers, as well as rating each state’s offerings.
The plans that tend to shine in other financial publications’ reviews include the Utah Educational Savings Plan, Ohio’s CollegeAdvantage, the Maryland College Investment Plan, and Nevada’s Vanguard 529 College Saving Plan.
Finally, attempt to persuade your kids to choose a degree that has greater chances of paying off (unlike these degrees). Yes, choosing a career you enjoy is important, nearly crucial. But college is an investment, and like every investment, there should be a cost-benefit analysis. Going into a huge amount of debt for a low-paying career makes paying for a car, paying for a home, raising a family, and taking vacations — also important factors in life satisfaction — much more difficult.
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