What College Investment Options Do I Have?

As tax laws change, college investment planning becomes increasingly complex. The most beneficial strategies for creating a college fund are quite similar to other investment tactics. Investment products that are tax deferred, tax exempt, or transferable without tax consequences can be especially advantageous.

This is even more effective if you do your planning early.

One important aspect of an investment is its balance of yield and risk. Determine the amount of risk you can tolerate, given the amount of time you have to recover from any potential losses.

Take the time to familiarize yourself with the financial aid formulas. This will help you determine whether assets and income should be in your name or your child’s name. Structuring your investments ahead of time can have a significant effect on the net amount of funds available for your child’s education.

There are a number of funding options available for your college investment plan. This list contains a few of the more common.

Certificates of Deposit

CDs offer a reasonable return with a relatively high degree of safety. They are FDIC insured and offer a fixed rate of return, whereas the principal and yield of investment securities will fluctuate with changes in market conditions.

The interest earned on a CD is taxed as ordinary income. And CDs are not very liquid. You will pay a significant penalty for withdrawing money before it reaches maturity.

Bonds

Many people consider U.S. government bonds to be among the least risky investments available. They are guaranteed by the U.S. government as to the timely payment of principal and interest.

The interest on Series EE bonds is tax-free to low- and middle-income families if the proceeds are used to fund a college education. This benefit phases out for individuals and couples in the upper middle class and above.

Zero-coupon bonds are purchased at a substantial discount and pay their face value upon maturity. The value of these bonds is subject to market fluctuation. Because they do not pay interest until maturity, their prices tend to be more volatile than bonds paying interest regularly. Thus zero-coupon bonds make it possible to buy high-quality bonds for far less money up front. Interest income is subject to taxes annually as ordinary income, even though no income is being paid to the investor.

Stocks and Mutual Funds

Many people who use stocks to fund a college investment program invest in mutual funds.

Mutual funds are professionally managed. They buy and sell securities to meet the specific goals of their fund, weighing risk against security, yield against quality. They can be an effective addition to a college investment plan. Investment return and principal value of these investments will fluctuate. An investor’s shares, when redeemed, may be worth more or less than their original cost. As with all investments, there are fees and expenses associated with mutual funds.

Tax-Advantaged Vehicles

In addition to taxable investments, two popular tax-advantaged funding vehicles are Section 529 plans and Coverdell Education Savings Accounts. Both programs feature withdrawals that are free of federal income taxes when used for qualified education expenses.

Section 529 plans are state-sponsored. It is up to each state to decide whether it will offer such a plan. Some 529 plans are set up as prepaid tuition plans, and some are structured as savings plans. With prepaid tuition plans, families can lock in today’s  tuition rates for future tuition costs at in-state public colleges and universities.

As with other investments, there are generally fees and expenses associated with participation in a 529 savings plan. There is also the risk that the investments may lose money or not perform well enough to cover college costs as anticipated. The tax implications of a 529 plan should be discussed with your legal and/or tax advisors because they can vary significantly from state to state. Most states offer their own 529 plans, which may provide advantages and benefits exclusively for their residents and taxpayers.

Coverdell Education Savings Accounts (ESA) are the other alternative. Although annual contributions to an ESA are much lower than to a 529 plan, investors generally have much more investment flexibility. Annual contributions of up to $2,000 per child under the age of 18 can be made to an ESA . Earnings on contributions accumulate tax deferred, and distributions are free of federal tax as long as the amount does not exceed the qualified higher-education expenses of the eligible student during the year. The amount that can be contributed gradually phases out for donors with higher incomes.

As with other investments, there are generally fees and expenses associated with participation in an ESA. There is also the risk that the plan investments may lose money or not perform well enough to cover college costs as anticipated. Nonqualified withdrawals are subject to federal and state income taxes and a 10 percent income tax penalty.

Before investing in a 529 savings plan, please consider the investment expenses, risks, charges, and expenses carefully. The official disclosure statements and applicable prospectuses, which contain this and other information about the investment options and underlying investments, can be obtained by contacting your financial professional. You should read this material carefully before investing.  

Remember also that mutual funds are sold by prospectus. The prospectus contains important information about the fund, including its investment objectives, risks, charges, and other matters of interest. You can call your financial professional for a prospectus about a fund that interests you. Read it carefully before you invest.

Making Choices

There are college investment options to fit almost any investor. No matter how modest or how ample your income, careful planning is the best way to “find” the money for college. The key is to start early and remain consistent.  

GE 47236 (12/08)

This material was written and prepared by Emerald Publications.
© 2009 Emerald Publications