Saving for Your Child's College Education

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Is paying for a college education looming in your future? Numerous articles and financial experts advise getting started early to take advantage of compound interest—the closest thing to magic in terms of making your money grow. A few dollars each week can turn into thousands by the time your child is ready for school. But before you can experience the wonders of compound interest, you'll need to learn about the various savings options available to you.

Mutual Funds and Taxable Savings Accounts

The vehicle you are most likely using to save for retirement is also a good way to save for your children's educations. Mutual funds offer higher-than-average returns (that interest thing again) on your money, meaning you can save more, faster. Funds also offer a variety of investment options. Unlike some other plans, the money can be used for anything. For instance, if your child gets an athletic or academic scholarship, you can use the mutual fund money to pay for housing or personal expenses.

But there are drawbacks, namely market risk and taxes. Since a portion of your fund may be invested in the ever-fluctuating stock market, you cannot predict the growth of your fund with rock-solid accuracy. If the market goes south, then so will your fund's earnings. Additionally, you will have to pay taxes on dividends and capital gains the same as any other investment. There are tax-efficient and tax-deferred funds that can help minimize tax consequences. With a myriad of mutual funds to choose from, a financial advisor can help you find the one that is right for your situation.

Coverdell Education Savings Accounts

Coverdell accounts are great for lower- and middle-income families. They are easy to open and contributions are easy to make. You can open an account at most banks, brokerages, and mutual fund firms, usually without a minimum opening balance. They can be used to pay education expenses for private schools at the elementary and high school levels, as well as for college. And you're not just limited to financing tuition—you can also use the money to pay for books, computers, and school supplies.

Annual contributions are limited to $2,000 and there is an income phase-out. Married couples who make more than $220,000 and single parents with incomes over $110,000 cannot participate in the Coverdell program.

529 Savings Plans

These plans offer the best deal in terms of tax implications. The funds in them grow tax-deferred. They are not subject to federal tax when withdrawals are made for educational expenses. Although if you invest in an out-of-state plan, some state taxes may apply.

Withdrawals are not considered income for the parents or the students, which means they do not affect financial aid eligibility. If your child decides not to attend college, you can transfer the funds to another family member. The tax provisions are currently scheduled to disappear in 2010, but both houses have introduced bills to make the 529s permanently tax-free.

However, the plans are not perfect. You can only make cash contributions, meaning you cannot transfer stocks or money from another account into a 529 plan. Most plans limit the funds in which you are able to invest. A number of states have received complaints about inconsistent fee disclosures. If you decide on a 529, make sure you get the fee information clarified, preferably in writing.

Upromise and Other Incentive Programs

While you cannot transfer stocks into 529 plans, you can transfer the cash proceeds from incentive programs into the plan. These incentive programs are also known as loyalty or affinity programs. They offer a rebate to customers in exchange for shopping at certain retailers. The best-known program is Upromise.

Like most other incentive programs, Upromise requires you to open a credit card which they use to track your purchases. Every time you purchase from a participating retailer, Upromise gives you a percentage back in rebates. The rebate money is placed in an account. You can transfer the rebate money into a 529 plan, savings account, or a mutual fund. Alone, the incentive programs won't make much of dent in your child's tuition costs. However, they can be used to supplement other accounts.

With a little pre-planning, you may be able to save more easily for your child's college education. Remember, higher education doesn't come cheap. The sooner you get started saving, the better.