Planning for education

How much will it cost?

The first task is to estimate the cost of education. Consider what schools you want your child to attend K – 12. Are they private or public? If you are planning to pay for private school, will you be able to do it with earnings or do you need to start saving for this at birth? See below for the best way to start saving.

According to the College Board the average tuition costs for the 2001-2002 school year were $3,754 for a public four-year college and $17,123 for a private four-year college. Those price tags are up 7.7% and 5.5%, respectively, from the previous year. College costs have risen at a rate that has far outpaced inflation.

Add in room and board and other expenses and those annual average costs jumped to $11,976 for a public school and $26,070 for a private school. That's just for one year. Multiply that amount by the number of years and number of degrees you want to fund.

Here's some good news. For the 2001-2002 school year:

• More than 40% of students attending a four-year college paid less than $4,000 in tuition and fees.

• Almost 70% of students attending a four-year college paid less than $8,000 in tuition and fees.

• Only 6% of students attended schools that charge $24,000 or more for tuition.

There's a big difference between the price tag of a college education and what people actually pay. A lot can be done to keep college costs under control, from choosing a reasonably priced school to grabbing a piece of the annual $74.4 billion financial aid pie.

Getting Started

So how much will it really cost? Saving for college is like saving for any other big expense. Follow these steps to determine a monthly amount you should sock away to make sure your children will have enough to attend college.

Here are the questions you need to answer to get an accurate estimate of costs:

• Tuition and expenses in today's dollars. If you're confident that your child will go to a public institution, then use the current average costs for a state school. If you're shooting for a private school, use those average costs. However, if you're not sure, try some in-the-middle numbers.

• Years of college. Do you want to cover the expenses for an associate's degree (two years), bachelor's degree (four years), master's degree (five or six years), or doctorate (can be up to ten years for some professions)?

• Years until college. Since most students go straight from high school to college, subtract your child's age from 18 and you have how many years until you begin this expense.

• College savings to date. Is there anything in the college fund already? Have your parents or family members offered to help?

• Estimated rate of return on investments. What kind of growth do you expect from your investments? Keep in mind that, as your child nears college enrollment, you should be investing more conservatively. If you're not sure what to input here, try a number between 6% and 8%.

• Estimated college inflation rate. Since 1971, college costs have grown an average of 7.7% a year. However, that figure includes the high-inflation '70s and early '80s. For this variable, you might choose a smaller number -- perhaps 6%.

• Your federal tax rate and your state tax rate. These rates are important only if you are saving for college through a regular bank or brokerage account, and not through a tax-advantaged Coverdell Education Savings Account or 529 plan (topics we'll cover later).

With this information we can help you figure out what you can afford, how much more you may need to save, and what savings vehicle will work best for your individual situation.

Don't get scared out of saving

Some people, when they see such astronomical price tags attached to a college degree, do something extraordinary: they do nothing. They figure there's no way to save that much without short-hanging other goals, so they cross their fingers and hope their child will win large scholarships.

Don't fall for this trap. If you start soon enough, you can have a large chunk of higher-education money. If as soon as their child is born, a couple invests $100 a month and earns 8% per year, they'd have almost $50,000 in 18 years (assuming they utilize a tax-friendly savings vehicle, which we'll discuss presently). That's $50,000 less that you or your kid will have to borrow.

Even if your child is in high school and you haven't saved a dime, don't give up. Whatever you do… do whatever you can. Really, every little bit helps.

Which kind of account should I use?

The first question you need to answer is whether you should enroll in a prepaid tuition plan. Here are the main considerations:

Prepaid Tuition Plans

Why a prepaid tuition plan is right for you:

• You're risk-averse.

• You like knowing your tuition will be covered.

• You don't think you'll be eligible for financial aid. Unlike the other options, assets in a prepaid tuition plan reduce financial aid eligibility dollar-for-dollar.

Why a prepaid tuition plan is wrong for you:

• A prepaid plan is not offered by your state or by the school your child wants to attend, or you want them to attend.

• You have no idea where your child will go to college.

• You prefer to choose your own investments.

• Your children are young, so the longer time horizon will allow you to be more aggressive with your investments, potentially resulting in more money.

If you'd rather use an investment account to fund your or your child's college education, then you have another choice to make: Should you choose a Coverdell ESA or a 529 savings plan? Here are the most important considerations:

Coverdell ESA

Why a Coverdell ESA is preferable:

• Distributions are tax-free. So are distributions from a 529 plan -- until 2011. It's likely that Congress will extend the tax-free treatment of distributions, but it's not a sure thing.

• You choose the investments. You can invest in the stocks, bonds, mutual funds, or cash. With a 529 plan, you must choose a money manager. On top of that, since most 529 plans are relatively new, these accounts have short histories, making it difficult to evaluate their quality.

• Funds in a Coverdell ESA can also be used for eligible primary- and secondary-education expenses.

529 Plans

Why a 529 savings plan is preferable:

• The control over the funds in the 529 will always reside with the contributor. This is not true with a Coverdell ESA, since it is a custodian account. Assets in a Coverdell ESA become the property of the beneficiary at age 18, and he or she can use the money for college or for anything else.

• The contribution limits to 529 plans are significantly higher.

• Assets in a Coverdell ESA are considered property of the student, which can reduce the student's financial-aid package. On the other hand, the assets in a 529 savings plan belong to the account owner.

• Your state may offer a tax deduction for contributions to the local 529 plan. Also, some states offer other perks, such as scholarships and matching contributions.

Investors can simultaneously contribute to a Coverdell ESA and both types of 529s. Why would you do this? Here are a few scenarios:

• You want to diversify. You want some of your money to lock in a portion of future tuition costs through a prepaid plan, but you also want to see if your investing prowess can provide a better return.

• You've decided to enroll in a prepaid tuition plan, but you'd also like to save for room and board, (which aren't covered by some prepaid tuition plans).

• You want to get the state tax deduction by investing in your state's program, but you don't want all your college savings in the hands of money managers, so you open a Coverdell ESA and make your own investment decisions.

• Your kids will go to college after 2010, and you don't want to risk Congress not extending the tax-free status of 529 withdrawals. So, you put the first $2,000 in a Coverdell ESA, and put the rest in a 529 plan.

• You anticipate that your child will attend private elementary and/or secondary schools, so you contribute to a Coverdell ESA (which can be used for pre-college education costs). However, because contributions to a Coverdell ESA are limited to $2,000 a year, you are concerned that the funds in the account will not be enough to pay for elementary, secondary, and post-secondary school, so you contribute to a 529 plan as well.

Just do something! Don't let all these deliberations prevent you from socking away some money as soon as possible. Saving something is much better than delaying while you solve the college account conundrum.

Due to the higher contribution limits and favorable financial-aid treatment, 529 savings plans offer the best benefits for most people. If your state offers benefits for participating in its 529 plan, and the plan offers at least five investment options that don't charge more than 1.25% annually, then consider signing up with your home state. If you decide later that it isn't the best plan for you, transfer to any other 529 plan.

If you're leaning toward a Coverdell ESA but still have doubts, go ahead and open one. The funds can be transferred to a 529 plan without penalty. (However, the other way around -- taking money from a 529 plan and putting it in a Coverdell ESA -- will incur distribution penalties, and this won't get you around the $2,000 annual contribution limit.) You can switch later if additional research and/or financial-aid considerations convince you that a 529 plan will be better. (If you're making the switch for financial-aid reasons, make sure the transfer is completed before Dec. 31 of your child's junior year in high school.)

So don't delay -- start saving NOW!

Financial Aid

The type of college savings account you choose will likely play a role in how much financial aid you or your student will be offered. We'll take a look at how each type of account affects aid eligibility, but let's first get a few things straight about financial aid:

• When it comes to calculating a student's expected family contribution (EFC), income is a bigger factor than assets. It is important to consider how your college savings account might affect aid eligibility, but it's not as important as what shows up on the student's and parents' tax returns.

• The vast majority of financial aid comes in the form of student loans. You may be offered a smaller financial aid package if you've saved over the years, but that usually just means you'll be offered smaller loans.

• In the EFC calculation, who owns the college savings account is important. The federal formula factors in 35% of the student's assets, but just 5.6% of the parents' assets. Therefore, if you're looking to increase your chances for a generous aid package, keep assets in the parents' name.

Now, let's see how each type of college savings account affects aid eligibility.

• Coverdell ESAs: The assets in a Coverdell ESA belong to the student. As stated earlier, the EFC calculation factors in a bigger chunk of a student's assets. Therefore, a Coverdell ESA is not as financial aid-friendly as a 529 plan under the control of someone else.

• 529 prepaid tuition plans: Accumulated credits in a prepaid tuition plan are considered the student's resource, and thus can reduce a student's eligibility for aid dollar-for-dollar. In other words, a prepaid tuition plan can significantly reduce the aid package offered to the student. Though that sounds bad, it's better to plan on not getting aid, rather than not planning at all and hoping for aid. Also, participation in a prepaid plan will not affect all aid, such as Pell grants and Stafford loans.

• 529 savings plans: The assets in a 529 savings plan are considered property of the account owner, not the student (unless the account owner is the student). If the account owner is a parent, then 5.6% of the assets in a 529 savings plan will be factored into the EFC. If the account owner is someone other than a parent or the student -- such as a grandparent or friend -- then the assets won't be factored into the EFC calculation at all.

Financial-aid practices change all the time. For example, there is a move afoot to have prepaid plans treated just like 529 savings plans. Therefore, check regularly with the Department of Education and prospective schools to monitor policy changes.

Barbara Bachelder, CFP® for Wealth by Design, LLC