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There are many ways to save for college. Let’s focus on three (529 Plans, Roth IRA’s and taxable Target Date Retirement Plans). Why these three? I think they are your best options when you factor in taxes, growth of capital, cost, flexibility and convenience.
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You want a plan that is FLEXIBLE. You want very cheap fees and no commissions. You want to really understand what you are doing and what you are investing in. Let’s take a look.
529 Plans
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What is a 529 Plan? A 529 is an investment plan specifically designed for your child’s college education. They are tax-deferred (you do not pay yearly tax). They are usually tax deductible (the majority of the states who have a state income tax offer their residents a tax deduction; there is no federal tax deduction). They are tax-free (must be educational expenses). They are flexible. (If your child receives scholarships or grants that pay for their college you will not be penalized with a 10% penalty for taking money out of the account. You WILL have to pay ordinary income tax, though.) You can use a 529 from another state. Large amounts of money can be contributed ($300,000 in many states). They have many investment options. They can offer very low fees. (DO NOT pay a broker to open a 529.) Most 529 plans are cheap to start ($25 is the minimum for many).
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Now those are a lot of goodies, don’t you think? So what are the drawbacks? There are many rules. If your child does not go to college, you will pay a penalty (if the money is not used for college and there are no scholarships or grants involved you will pay a 10% penalty on any withdrawals from the account and state and federal income taxes on any withdrawals that have not been taxed).
Roth IRA’s
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The Roth IRA is a retirement account that has morphed into something much more versatile in how it can be used. IF you have a good retirement fund elsewhere (401K, TSP, 457, 403b, SEP, Pension, etc.) you may consider using your Roth IRA as a way to fund your child’s education. It will be tax-deferred (same as the 529). It will be tax-free. (specifically the principal you have put in). It is simple (fewer rules). Many options are available. It can be cheap (select cheap index mutual funds or target date funds at vanguard.com). They are flexible. (If your child does not go to college or gets scholarships, you can keep the money in your retirement account and use it for you.) You can go to college anywhere. (Roth IRA’s are easy to use and easy to take money out.) There are some drawbacks.
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It’s your retirement account. (This means there will be less money for your future retirement needs and if this is your only retirement account you SHOULD NOT DO IT.) It is not tax deductible. (The money that goes into a Roth IRA goes in after taxes.) You are limited by how much you can put in (verify the current year contribution limits).
Taxable Target Retirement Account
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A Target Retirement Fund owns many types of assets so you don’t have to do it yourself. Let’s say your child is 2 years old and it is the year 2011. In 16 years (hopefully) that child will be ready for college so you could choose to place his money in a 2025 fund or a 2030 fund. These funds gradually become more conservative in their investments as time goes on (they reduce the stock portion of the fund and add to their bond and cash portion). So by the time your child is ready for college you will have a relatively conservative fund to start accessing. It is the most flexible (you can do just about anything with it). It can be cheap. (buy a target date fund that owns index funds). You can go to college anywhere. There are many options. (Vanguard has many target retirement funds). It is simple (you can use the money for anything you want). You can put in as much as you want (no yearly limitations). Yes, there are drawbacks as well.
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There is no tax deduction (this is after tax money). It is not tax-free (you will pay taxes on the capital gains and dividends each year). You need a little bit of money to get started (the Vanguard target retirement funds require $1,000 to start).
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So where do we go from here? I would certainly encourage you to investigate all of your options before you invest your money. The Best Way to Save for College, A Complete Guide to 529 Plans by Joseph Hurley is a wonderful book that explains everything you could possibly want to know about these investments.
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BIG POINT: If you decide to go with a 529 Plan, DO NOT use a broker! Go directly with the state or Vanguard and avoid any commissions (you can Google your state 529 Plans and find the folks who run the program).
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I would start investing in the account that best suits me as soon as I had a birth certificate and then I would dollar cost average money into that fund each and every month. I would encourage family members and friends to reduce the presents on their birthdays and Christmas and instead tell them that money put towards their college fund would be greatly appreciated.