The Best Way For Families To Save For College

A college education is a pre-requisite for most skilled jobs in the United States. And the cost of a college education has been rising faster than inflation for many years. Yet few families have fully developed a specific plan for financing the college education of their children. Indeed, half of American families with children under age 18 are not saving for college at all, according to a report by Sallie Mae.

Some families may be counting on government grants or college scholarships for their children. But these are becoming harder to obtain as the returns of university endowments have declined and the pressure on the federal budget has increased. Other families may be prepared to turn to student loans. But there are far too many college graduates struggling to pay down these loans in the midst of a weak job market.

Instead, families with children would be wise to start saving through a 529 plan, which are run by almost every state. Parents may contribute as much as they like each year to a 529 plan (although the wealthy need to consider gift tax issues); professional money managers then invest those contributions in diversified asset pools.

Furthermore, parents can list all of their children as potential beneficiaries. So, if one of their children decides not to attend college, the funds in the 529 plan can help finance the college education of any of their other children.

Most importantly, 529 plans receive a generous federal tax subsidy. First, the money in the account grows free of income tax. Second, if individuals use the funds to finance tuition, room and board, or other qualified expenses, then withdrawals are also free of income tax. In other words, the investment returns of a securities portfolio over 18 years or more are tax-free if used to pay for a college education. If used for non-educational purposes, however, 529 plan earnings are usually subject to income tax plus a 10% penalty.

Almost every state offers a 529 run by professional money managers. Unfortunately, the fees and asset categories are quite different from state to state, meaning that certain plans are better than others. If an individual is unsatisfied with his or her state's plan, he or she may choose to invest in any 529 plan of any state-and keep the federal tax subsidy. Nevertheless, approximately 30 states offer extra tax benefits to their residents if they contribute to their own state's plan, so that may be the best route for many families to take.

Despite all these federal and state tax incentives, 529 plans are not very popular. According to the Government Accounting Office, only 6% of families with children have a 529 plan (or its cousin, a Coverdell account). According to the report by Sallie Mae, only 37% of families without a 529 plan even knew that such plans were available to them.

So what should be done to promote the use of 529 plans? Here is a simple and low-cost plan.

1) The Department of Education should work with the states to make American citizens more aware of the tax benefits of 529 plans. This would be a nationwide marketing plan for 529 plans aimed at couples with young children, rather than the current state-by-state approach to 529 marketing.

2) The Department of Education should work with consumer groups to establish a website comparing the 529 plans of each state. This comparison should include investment portfolios and expenses as well as local tax benefits.

3) Congress should allow parents to transfer the monies in a 529 plan to a Roth IRA if none of their children decide to attend college by age 30. This rule would not undermine the income and contribution limits that usually apply to a Roth IRA, since the rule would come into play relatively rarely. But the rule would allow parents to start contributing to a 529 plan when their children were young-without fearing that their money would be taxed away if their children decided not to go to college.