Parents Need a Strategy to Cope With College Costs

Any parents who expect their children to go to college one day have probably thought--or worried--about how they were going to finance that education.

Some financial experts maintain that four years at a private college will cost upward of $200,000 by the time today’s toddlers are ready to enroll. That would require parents--assuming an 8% annual return on their money--to set aside $500 per month per child for the next 16 years. Someone with a 14-year-old, whose education costs are estimated at $100,000, would have to save nearly $1,800 a month to pay the tab.

Public colleges are less expensive. Still, some parents give up, thinking it’s pointless to save when there is no chance they’ll have enough.

However, having at least some money set aside could be pivotal in ensuring that your kids get a quality education without bankrupting you. And there are dozens of ways to parlay relatively small amounts into substantial nest eggs if you start when the child is young.

But before you decide on a savings strategy, you need to consider some of the basics.

There are essentially two dueling factors that affect college savings: taxes and financial aid for students.

The trend in recent years has been for parents to put money away in their children’s names as a way of saving federal tax on their children’s college funds. Until investment earnings on a child’s account exceed $1,100 per year, the federal government taxes the earnings at a child’s rate--usually under 15%. It is not until a child’s investment earnings exceed $1,100 that they’re taxed at a parent’s rate, which can top 33%.

But this may be a poor strategy for those who will ultimately need to tap some sort of federal or state student financial aid program--and that group may include the bulk of the middle class.

The reason why relates to how the federal government calculates financial aid eligibility for students. The formula is complex, but the thought behind it is that both parents and students should contribute to the child’s college costs. Where parents are expected to contribute a relatively modest amount of their assets to finance the student’s bills, the student is expected to use virtually all of his or her assets to pay for college before financial aid will be granted.

For example, a parent with $10,000 in assets would be expected to contribute $560 toward the student’s first year of college, said William E. Stanford, director of financial aid at Lehigh University in Bethlehem, Pa. A child with the same nest egg would be expected to contribute $3,500.

The parent’s contribution would drop to $529 in the second year, while the child’s contribution would drop to about $2,275, and so on.

There are ways to reduce current taxes without jeopardizing future financial aid, but they may not be the best ways to save for college.

One of the simplest tax-advantaged savings strategies is buying Series EE U.S. Savings Bonds. Parents who earn less than $60,000 jointly ($40,000 for a single parent) and who use the proceeds--both principal and interest--from the redemption of the bonds to pay college tuition and fees pay no federal tax on their interest earnings.

But the bonds, which must have been purchased after 1990, must be registered in the parent’s name (not the child’s) and they must be redeemed in the year the college expenses are paid. Also, tax benefits are cut if parents earn more than the threshold amounts in the year the bond is cashed or if the child’s tuition and fees are less than the total redemption amount of the bond.

Because the bonds don’t pay interest until they mature, they sell at a steep discount to their maturity value.

An alternative for those who want to save small amounts over time is investing in mutual funds. Many mutual funds will allow you to invest as little as $25 monthly.

There are literally hundreds of investment choices for those who opt for mutual funds, including some--such as government and municipal bond funds--that provide tax benefits.

But those who have plenty of time before the money is needed, and who don’t mind taking risks, may be better off investing in stock market funds.

Over the long haul, the funds usually appreciate faster than bond funds. And the higher appreciation can more than make up for the loss of tax breaks.

For example, if you invest $50 each month in a stock market mutual fund, you could easily accumulate $20,000 in 15 years, assuming your average return exceeds 10%--which is likely, based on historic stock market performance.