Saving for College: Strategies for Success

Updated February 2, 2012

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

It's never too early to start investing for a child's college education. There are no guarantees with the market, but the longer your time horizon, the better—the sooner you start, the more time your money has to potentially benefit from the power of compound growth, which is growth on top of growth.

If you want to keep up with rising college costs, you should try to invest for growth. Historically, stocks have offered the best chance for your money to grow over the long term. If college is 10 or more years away, consider investing primarily in stocks and/or stock mutual funds.¹ Then, gradually move those funds to more conservative holdings as your child nears college age.

Is it ever too late to start?

What if you've put off saving, and college is only a couple of years away for your child? Should you skip saving altogether and hope for financial aid or fall back on loans? Not necessarily—saving late is better than not saving at all. Remember, college costs don't arrive all at once; they trickle in over four years (at least). Even if you wait until the last minute, you still have an opportunity to invest for college. If you're in this situation, you'll want to consider investments with a shorter time horizon.

The first part of your strategy: Choosing the right account for you

The government has created two accounts—529 plans and Education Savings Accounts (also known as Coverdells)—to help you save for your children's college education. These accounts provide many advantages over custodial accounts, general brokerage accounts and savings accounts.

• A 529 plan is a state-sponsored program that allows parents, relatives and friends to invest for a child's college education. Generally, you can choose from a selection of age-based or static investment portfolios that are professionally managed by the program's fund manager. The account belongs to you, not your child, and any potential earnings grow tax-deferred—which means that your money has a chance to compound faster because you don't have to pay taxes on current investment income or capital gains. What's more, you pay no federal taxes on withdrawals as long as they're used to pay for qualified educational expenses.
  
  529 plans don't limit how much you can contribute per year. Instead, they have a lifetime contribution limit (often greater than $200,000) per beneficiary that varies by state.
• An Education Savings Account (ESA) is managed by you on behalf of your child. You can invest the money you contribute to an ESA in stocks, bonds, mutual funds—pretty much whatever you're comfortable with. When your child turns 18, you can choose to hand over the reins or continue managing the account yourself.
  
  ESAs provide tax advantages similar to 529 plans: Your money grows tax-free and you pay no taxes on withdrawals if they're used to pay for qualified educational expenses. However, ESAs can be used for certain elementary or secondary school expenses as well as for college expenses. You can contribute a maximum of $2,000 annually, if you qualify.²
• A custodial account is an account managed by a parent or guardian on behalf of a child. The money belongs irrevocably to the child, so if you're managing a custodial account for your daughter, when she turns 18, 21 or 25 (depending on the state rules governing the account), she can use the money for anything she wants—a new car or a European vacation, for instance.
  
  Custodial accounts offer minor tax advantages and have no restrictions on how the money can be spent, as long as it's for the benefit of the child. If you want to set aside money for expenses that aren't covered by an ESA or 529 plan—sorority dues or private voice lessons, for example—a custodial account may be just the thing.
• You can use a brokerage account to invest for college, but it offers no tax advantages. A 529 plan, an ESA or even a custodial account is probably a better choice. However, supplementing your tax-advantaged college investments with a taxable brokerage account sometimes makes sense—for example, if you want to save money for nonqualified college expenses and maintain control of the money.
• A savings account may be a place to put away a few dollars for a rainy day, but it's a poor choice for college savings. Savings accounts usually don't even keep up with inflation, much less rising college costs.

The second part of your strategy: When and how to invest your money

18 years before college

• Open the account of your choice and contribute money every month, perhaps by signing up for an automatic investment plan. Contribute extra money whenever possible.
• If appropriate given your risk tolerance, invest the money in stocks or stock mutual funds for long-term growth.

8 to 10 years before college

• Has anything changed in your life? A new baby? A better-paying job? Consider these changes and recalculate your needs.
• If you haven't yet opened an account, do so right away. You may want to go with a 529 plan, which allows much larger lump sum contributions and may give you a chance to make up for lost time.
• Contribute any windfall money to your college savings account.

1 to 2 years before college

• Several years out, you can ballpark your Expected Family Contribution (EFC)—a number that financial aid officers use to determine a student's financial need—using an online calculator such as the College Board's EFC Calculator. This will give you some idea of what results to expect when you fill out the Free Application for Federal Student Aid (FAFSA), which generates the official EFC that most schools rely on.
• Fill out the FAFSA as soon after January 1 as possible in the year your child expects to enroll. It's worth filling out even if you don't expect your child to qualify for aid based on your income, because the FAFSA considers other factors (such as cost of living, family size, the number of family members in college, and the age of the older parent) to determine a student's eligibility for federal and state grants, work-study programs, and loans.
• Look into other options for financial aid and scholarships. 
• Reassess the risk level in your accounts. As college approaches, consider moving the money into less risky investments, such as shorter-term bonds and money market funds.  

Comparing 529 Plans, Coverdell ESAs and Custodial Accounts

1. While growth investments (equities and equity mutual funds) offer the potential to keep up with rising college costs, they put your principal at greater risk than income securities and bank products.

2. The annual contribution limit reverts back to $500 in 2013 and K-12 expenses would no longer qualify, unless Congress extends the law. However, qualified withdrawals would continue to be tax free.

3. Full-time college students under the age of 24 are taxed at their parents' rate on unearned income in excess of $1,900, unless the students' earned income is greater than one-half of their support.