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February 20th, 2010, 04:17 PM
When your children are ready for college, will you be ready to send them? With college tuition across the country rising year after year, the sooner you begin a monthly or yearly investment program, the more confident you can be that the money will be there. Here are some ideas to think about and discuss with your financial advisor.
Custodial Accounts. One way to accomplish your education savings goal is to use a custodial account established under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). Custodial accounts are attractive to parents because the earnings on investments placed in these accounts are subject to tax in the child’s bracket (15% in most cases) in years when the child is 14 years old or older.
If your child is under 14, annual investment income (dividends and/or interest) up to $750 in a custodial account will be tax-free; another $750 will be taxed at the child's lower rate, with the excess over $1,500 taxed at your rate. In essence, earnings on the account are taxable at the parent’s highest marginal rate. If assets are invested in growth-oriented investments that pay minimal dividends or interest until the child turns 14, the impact of the “kiddie tax” can be minimized.
UGMA/UTMA accounts are irrevocable gifts of money to your child and control goes to him or her at the age of majority (which varies by state). If you want to maintain control of the assets, you can set up an account in your name earmarked for college funding, or consider one of the new Qualified State Tuition Plans.
Qualified State Tuition Plans or 529 Savings Plans. First authorized by Congress in 1996, qualified state tuition programs, or 529 college savings plans, allow states to offer investors professionally managed, tax-advantaged portfolios to help meet rising college expenses. The benefits for investors include tax-deferred accumulations of investment earnings, market-based returns from a portfolio of mutual funds, and complete control over withdrawals for the life of the account. Proceeds may be used at any accredited post-secondary school in the United States. Starting in 2002, qualified withdrawals are tax-free.
Slow but steady wins the race. If you have the chance to set up a college-funding account when your child is born, then it's easy to use this rule of thumb: For each year of the child's age, make sure the account's current value is at least 5% of the current cost of the kind of education you want to provide. For example, if the current cost of four years at the school you have in mind is $40,000 (be sure to include all costs: room, board, tuition, and expenses), and your child is 6 years old, the account's current value should be at least 6 x 5% x $40,000 = $12,000.
If you're starting later, you need to accelerate the process. For example, if you open your child's account when he or she is 8 or 10, keep an eye on college costs with a view to putting 10% of current costs into the account each year.
If the account is keeping up with college costs and your child's age, pat yourself on the back. If it's not, you can work with your financial advisor to make up the shortfall with any of the following kinds of investments, among others:
High-quality stocks. The prices of stocks, of course, do go down as well as up. But well-chosen stocks offer the opportunity for excellent long-term growth. In fact, stocks and stock mutual funds (discussed below) are the only types of securities that have consistently beaten inflation over long periods.
You can make the ups and downs of the market work for you through an investment discipline called dollar-cost averaging. The idea is to invest the same number of dollars every month (or every quarter, or every year), whether prices are currently high or low. The result is that you buy fewer shares when prices are high, more shares when prices are low. Over time, your average share price is likely to be lower than the average price of the stock over the same period.
Of course, you're still betting that the average share price when you sell will be significantly higher than the average price you paid. That's why it's important to choose high-quality stocks--stocks whose prices represent good fundamental value and are likely to move up strongly over the long term.
Mutual funds. Mutual funds investing in stocks can be a good long-term choice for college accounts. Here again, prices move up and down, so quality is important. Each September's first issue of Forbes is a special issue devoted to mutual funds. It includes the Forbes Honor Roll, which lists funds that have established good long-term results in both bull and bear markets.
Again, dollar-cost averaging can be a smart way to invest. You should also look for a family of mutual funds, to allow diversification as your portfolio grows.
Zero-coupon bonds. Zero-coupon bonds (also known as "zeros") are nothing more than a traditional bond with no interest payments. Instead of paying a semi-annual coupon, zeros are purchased at a deep discount and then repaid at par at maturity. Although zeros are most often U.S. Treasury issues, a zero-coupon bond can also be a corporate or a tax-free municipal bond. These bonds compound at a predetermined rate of interest on a semi-annual basis until maturity.
For example, a 7% zero with a 20-year maturity will currently cost $2,584 and will repay $10,000 at the end of the 20-year period.
You can select maturity dates in each of the four years when tuition will be needed. With most zeros, the interest is taxable each year, although you don’t receive it until maturity. However, zero-coupon bonds on which the accumulating interest is non-taxable (known as “tax-free zeros”) are also available.
Municipal bonds. Municipal bonds pay interest exempt from federal taxes, and often from the taxes of the state in which they are issued. You can buy a bond (ordinarily for the face value of $5,000) and have the interest payments accumulate tax-free until the face value is paid back at maturity.
Variable annuities. This popular investment combines four important advantages into one plan for college-education funding:
• Professional portfolio management through mutual-fund investments (stock, bond, money-market, international, and balanced funds)
• Money grows on a fully tax-deferred basis
• Monthly, quarterly, or semi-annual dollar-cost averaging--through direct withdrawals from a checking account, if you wish
• Protection of principal for your beneficiaries in the event of an untimely death
Custodial Accounts. One way to accomplish your education savings goal is to use a custodial account established under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). Custodial accounts are attractive to parents because the earnings on investments placed in these accounts are subject to tax in the child’s bracket (15% in most cases) in years when the child is 14 years old or older.
If your child is under 14, annual investment income (dividends and/or interest) up to $750 in a custodial account will be tax-free; another $750 will be taxed at the child's lower rate, with the excess over $1,500 taxed at your rate. In essence, earnings on the account are taxable at the parent’s highest marginal rate. If assets are invested in growth-oriented investments that pay minimal dividends or interest until the child turns 14, the impact of the “kiddie tax” can be minimized.
UGMA/UTMA accounts are irrevocable gifts of money to your child and control goes to him or her at the age of majority (which varies by state). If you want to maintain control of the assets, you can set up an account in your name earmarked for college funding, or consider one of the new Qualified State Tuition Plans.
Qualified State Tuition Plans or 529 Savings Plans. First authorized by Congress in 1996, qualified state tuition programs, or 529 college savings plans, allow states to offer investors professionally managed, tax-advantaged portfolios to help meet rising college expenses. The benefits for investors include tax-deferred accumulations of investment earnings, market-based returns from a portfolio of mutual funds, and complete control over withdrawals for the life of the account. Proceeds may be used at any accredited post-secondary school in the United States. Starting in 2002, qualified withdrawals are tax-free.
Slow but steady wins the race. If you have the chance to set up a college-funding account when your child is born, then it's easy to use this rule of thumb: For each year of the child's age, make sure the account's current value is at least 5% of the current cost of the kind of education you want to provide. For example, if the current cost of four years at the school you have in mind is $40,000 (be sure to include all costs: room, board, tuition, and expenses), and your child is 6 years old, the account's current value should be at least 6 x 5% x $40,000 = $12,000.
If you're starting later, you need to accelerate the process. For example, if you open your child's account when he or she is 8 or 10, keep an eye on college costs with a view to putting 10% of current costs into the account each year.
If the account is keeping up with college costs and your child's age, pat yourself on the back. If it's not, you can work with your financial advisor to make up the shortfall with any of the following kinds of investments, among others:
High-quality stocks. The prices of stocks, of course, do go down as well as up. But well-chosen stocks offer the opportunity for excellent long-term growth. In fact, stocks and stock mutual funds (discussed below) are the only types of securities that have consistently beaten inflation over long periods.
You can make the ups and downs of the market work for you through an investment discipline called dollar-cost averaging. The idea is to invest the same number of dollars every month (or every quarter, or every year), whether prices are currently high or low. The result is that you buy fewer shares when prices are high, more shares when prices are low. Over time, your average share price is likely to be lower than the average price of the stock over the same period.
Of course, you're still betting that the average share price when you sell will be significantly higher than the average price you paid. That's why it's important to choose high-quality stocks--stocks whose prices represent good fundamental value and are likely to move up strongly over the long term.
Mutual funds. Mutual funds investing in stocks can be a good long-term choice for college accounts. Here again, prices move up and down, so quality is important. Each September's first issue of Forbes is a special issue devoted to mutual funds. It includes the Forbes Honor Roll, which lists funds that have established good long-term results in both bull and bear markets.
Again, dollar-cost averaging can be a smart way to invest. You should also look for a family of mutual funds, to allow diversification as your portfolio grows.
Zero-coupon bonds. Zero-coupon bonds (also known as "zeros") are nothing more than a traditional bond with no interest payments. Instead of paying a semi-annual coupon, zeros are purchased at a deep discount and then repaid at par at maturity. Although zeros are most often U.S. Treasury issues, a zero-coupon bond can also be a corporate or a tax-free municipal bond. These bonds compound at a predetermined rate of interest on a semi-annual basis until maturity.
For example, a 7% zero with a 20-year maturity will currently cost $2,584 and will repay $10,000 at the end of the 20-year period.
You can select maturity dates in each of the four years when tuition will be needed. With most zeros, the interest is taxable each year, although you don’t receive it until maturity. However, zero-coupon bonds on which the accumulating interest is non-taxable (known as “tax-free zeros”) are also available.
Municipal bonds. Municipal bonds pay interest exempt from federal taxes, and often from the taxes of the state in which they are issued. You can buy a bond (ordinarily for the face value of $5,000) and have the interest payments accumulate tax-free until the face value is paid back at maturity.
Variable annuities. This popular investment combines four important advantages into one plan for college-education funding:
• Professional portfolio management through mutual-fund investments (stock, bond, money-market, international, and balanced funds)
• Money grows on a fully tax-deferred basis
• Monthly, quarterly, or semi-annual dollar-cost averaging--through direct withdrawals from a checking account, if you wish
• Protection of principal for your beneficiaries in the event of an untimely death