Volume II - July 2010

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We Don't Need No Education?

Being a new father can present a lot of challenges.  Speaking from recent experience, I have a newfound respect for my own parents who no doubt encountered the same sleeplessness, late-night diaper runs, and life-altering schedule changes that come with the territory.  Now that I’ve gotten used to the daily routine, and Walter Jr. is progressing in a healthy and happy manner, the gravity of the responsibility has begun to set in.  Not only am I responsible for his well-being, but I need to save enough money to put him through college!

So, how do I do that in the most effective way?  First, it’s important to know how much college tuition is likely to cost and consequently how much I will need to save on a monthly basis to meet that goal.  This is, of course, an inexact science because we don’t know how the Markets will perform or how much tuition prices will inflate over that time.  Having done quite a few of these analyses, I would recommend using a conservative estimate for performance and an aggressive target for inflation: 6% and 5% respectively.  There is a very helpful savings calculator on www.cfnc.org if you are interested.

Once you know how much is needed, where do you start?  There are two main ways that most parents go about this: the Coverdell Education Savings Account and the 529 plan.  There are pros and cons to each method, but the main difference lies in the contribution limits and the taxation of each investment vehicle.

Let’s start with the Coverdell Account, sometimes referred to as an ESA.  Basically, the account is very similar to a Roth IRA.  Your contributions (max $2000 per year per child) are non-deductible but grow tax-free, and, if withdrawn for various educational reasons, are never taxed.  Also, like a Roth IRA, the money in an ESA can be invested in any stock, bond, or mutual fund available through your broker.  From a federal financial aid standpoint, the ESA is on equal footing with the 529 plan.  The account is considered an asset of the custodian, usually the parent, and withdrawals used for educational purposes are not reported as income to the student or parent.

The second option is a 529 plan.  These state-sponsored plans offer the same tax-free growth and withdrawal benefits as the ESA but differ in the contribution amount (up to $13,000 per donor per child per year in accordance with the federal gift tax regulation) and the potential tax deduction that is offered through many home state 529 plans.  North Carolina, for instance, provides contributors a state income tax deduction (usually 7 or 8%) for the first $5,000 of contributions per year.  This is a nice added benefit for using a home state plan, but it does not come without strings attached.  Unlike the ESA, 529 plans generally have a small set menu of funds to choose from that offer little flexibility.  For example, North Carolina only offers 15 choices that consist of Vanguard index funds.  Although your choice of funds is limited, these funds have very low expense ratios, and combined with the added home state tax deduction, are still the best deal in town.

In summary, both the ESA and 529 plans offer parents and other family members a great way to start saving for their child’s education.  For more information please visit our website and view our monthly video: this month features nationally syndicated talk show host Dave Ramsey.         

-Walter Hinson, CFP ®