How to Save for College

CONTEMPLATING future costs of a young child's college education calls for a sound heart, a cool head and aspirin for those worries that go bump in the night.

If college costs continue growing at the rate of 6% a year, as many economists predict, a bachelor's degree in the year 2008 could cost almost $176,000 at a private university and $82,400 at a public university. Assuming that the money you save will earn 7% annually after taxes, you would need to set aside about $4,250 a year to pay the costs at a private institution or about $2,000 for a public university.

A convenient parking spot for savings is the custodial account that comes under the UGMA (Uniform Gifts to Minors Act) or the UTMA (Uniform Transfers to Minors Act). They specify that if your child is under 14, the first $500 of annual investment income in his or her name is tax free; the next $500 is taxed at his or her rate (usually 15%); and any unearned income above $1,000 is taxed at your rate. Once your child turns 14, however, the income is taxed at his or her rate. The best strategy with custodial accounts is to concentrate initially on high growth, low income investments like tax free bonds or long term growth mutual funds, which pay little or no dividends. Once the child turns 14 and is taxed at a lower rate, the emphasis should switch to income generating investments like certificates of deposit, money market mutual funds or high yielding stock.

Families expecting financial aid might want to keep their college money in the parents' names rather than in a custodial account, as this could increase their aid package. Another reason is that custodial accounts come under the child's control after the age of 18. If you have qualms about leaving money in your child's name, you could consider setting up a minor's trust. The first $5,000 of its income is taxed at the 15% rate and additional earnings at 28%.

Bonds have become popular with parents saving for future college expenses, as they produce compound interest over the years and can be timed to mature when the child is ready to go to college. Reflecting the concern with growing college costs, various bonds have been issued to serve the specific needs of parents.

U.S. Savings Bonds pay tax free interest to those using them for college education, as long as the parents' joint incomes are $60,000 or less, or $40,000 or less for single parents. The interest exclusion phases out beyond that amount and disappear at $90,000 for couples and $55,000 for single parents.

College Savings Bonds, also known as "baccalaureate bonds," have been initiated through legislation by some 15 states in the last few years. They are municipal bonds, which are free from both federal and state taxes, and do not ultimately have to be used for college costs. Some states offer a cash bonus if the child attends a school within the state. In Illinois, for example, parents who pay around $1,000 for a bond now will collect $5,000 in twenty years. If that money goes toward a college education, and the child attends a public or a private school in Illinois, the family collects a $400 bonus.

Baccalaureate bonds belong to the larger family of zero coupon bonds, which get their name because you receive no income from the bond until it matures. You can buy a zero at a substantial discount and collect its face value when it matures. Although you receive no income until then, you have to pay taxes on the accrued interest except on municipal or state zeros, both of which are tax free. Tax free zeros are fast becoming one of the most attractive long term investments for college education. The risk with zeros is that in the long run their value fluctuates more than that of conventional bonds, as interest rates rise and fall.

The phenomenal increase in college costs has led to several creative means of financing, some of which are suffering teething problems. In state universities and colleges in Michigan, Florida and Wyoming, a guaranteed tuition plan allows you to pay the state a lump sum to buy four years of future tuition at a discount. However, the plan faces serious snags on the tax front. The IRS has ruled that while the purchaser of the plan is not liable for taxes, the child will be taxed on the earnings when he or she collects the proceeds, and the state also must pay taxes on its earnings.

Another recent college savings innovation is the College Sure CD, whose rate of interest is pegged to rising college costs. You do not receive the accumulated earnings until the child enrolls in college, but the interest is taxed like that of any certificate of deposit. Further, the upfront payment could reduce your total return.