Investing Step #6: College Saving

Photo by: Joe Shlabotnik

This post is step 6 in our Investing Template.

After retirement, the next farthest investing event is your kids’ college education.  While in some cases a first house may be sooner than college, or in more rare cases retirement might come before your kids go to college, generally money that is invested in College Savings Plans will be tied up the second longest, next to your Retirement Accounts.

Why College Savings Plans?

College Savings Plans, often referred to as 529 plans, allow you to contribute money towards future tuition, have that money grow tax-free, and if it is used for appropriate expenses, used without paying taxes.  Thus, while your contributions are not typically pre-tax, they grow without taxes and can be used without taxes, which can be a huge advantage.

Types of 529 Plans

There are two major variations in 529 plans:

• Prepaid Tuition: In this case you pay for tuition at today’s rates and they are locked in for the future.
• Savings Plans: These allow you to contribute your after tax dollars to grow tax free and offer various investment options.

Overall, 529 plans are implemented at state levels, or sometimes even at the particular institution level.  Thus you see a much wider variety in options and details than in many federal plans. 

Considerations

Due to the wide variety in the plans there can be many key details, but ultimately the primary consideration in these plans is the likelihood that this money will be used for college.   If it is not, then the money will be taxed when withdrawn, as well as a 10% penalty, similar to early withdrawal in a retirement account.  At the same time, college can be a major expense in a family’s life, and the tax benefits of these accounts can be huge.

When deciding if and how to contribute to a college savings plan, I typically recommend caution.  While these plans can offer huge savings if your child goes to an appropriate college, that is not a guarantee.  Many other expenses will definitely happen and are slightly safer options because you can guarantee their use. 

Still, this money should not be viewed as a terrible investment either way.  If you use a typical college savings plan for 15 years and then your child doesn’t go to college, you can withdraw that money with a 10% penalty.  While this may sound harsh, you’ve had 15 years of your gains compounding without taxes, which will generally overcome the 10% penalty.