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A friend recently asked where and how he should save for his eight-year-old, which reminded me of a big mistake we made saving for our daughter.
When she was born we set up a trust and kept contributing. Later we added a 529 college plan, thinking we had college costs covered. What we didn’t realize was that having money in her name would hurt her chances for need-based aid. When I later filled out the FAFSA I learned that student assets are counted much more heavily than parent assets. To illustrate: if parents have $100,000 in assets the government might expect them to contribute about $6,000; if a student has $100,000, the expected contribution can be around $20,000. Students typically won’t lose aid for up to $3,000 in their own bank accounts, but larger balances can reduce eligibility significantly.
A 529 plan, created under Section 529 of the tax code, is an education savings account available in most states. Money put into a 529 grows tax-free and can be withdrawn federal tax-free for qualified education expenses; state tax benefits vary. Importantly, the account is controlled by the donor, not the beneficiary, so the student does not have direct access to the funds. I recommend opening a 529 plan directly, though you can also work with a financial advisor.
The main downside to a 529 is if the beneficiary doesn’t attend college: withdrawals of earnings for nonqualified uses face income tax and a 10% penalty. That said, you can change the beneficiary to another child, a relative, or even yourself if you return to school. Savingforcollege.com is a good place to learn more about 529 options.
Another solid option is U.S. Series I savings bonds, which protect against inflation. Their interest rate is adjusted every six months based on inflation, plus there’s a fixed rate set when the bond is issued. They’re safer than CDs or bank accounts for long-term saving and work well for children’s savings.
If there’s any chance your child will need financial aid, avoid opening brokerage or other accounts in the child’s name. Instead, open an investment account in your name or jointly with your spouse and earmark those funds for your child. For long-term savings you can invest in a diversified portfolio of index funds. One simple approach is a global index fund—such as a total world stock ETF—which offers wide coverage of developed and emerging markets, low costs, and passive management.
Keep in mind stocks are volatile and can fall as well as rise. Because of that volatility, don’t invest money in the stock market that you’ll need within the next five to eight years. If market swings worry you, split your savings between I bonds (or other safer choices) and stock funds to soften the ups and downs.
Have you started investing for your child? What accounts or investments are you using?
