The looming Congressional bickering over expiring tax breaks, along with negligible interest rates on safe Treasury bonds, are causing dilemmas for parents hoping to find tax-free ways to save for their children's college educations
Adding to the confusion: the different rules each state has for "529" college savings accounts, named after the section of the tax code that created them. These IRAs for college expenses grow protected from federal taxes and are great deals for citizens of the 34 states that offer tax deductions for contributions. But for the citizens of the 16 states that don't give such a break, 529s can have drawbacks such as high fees and limited investing options.
[Learn the 4 steps to getting free money for college savings.]
College finance experts say that no matter what happens on Capitol Hill or to interest rates in the coming months, parents who have cash after paying their regular monthly bills can maximize their savings if they apportion the extra funds each month in this order:
1. Pay off credit cards and other high-interest debt. Your end-of-the-month financial statements will look much healthier if you pay down debt that is charging double-digit interest rates, advises John Heywood, a principal at mutual fund giant Vanguard.
[Check out U.S. News's College Savings Center.]
2. Increase your 401(k) deduction. Boost it to the maximum your employer will match, if you're lucky enough to get that benefit at work. Employer contributions are free money, so it makes sense to collect as much as possible, Heywood advises.
3. Consider a Roth IRA. If you live in one of the 16 states that doesn't give special tax breaks for 529 contributions, a Roth IRA might be your best bet. Those states are: Alaska, California, Delaware, Florida, Hawaii, Kentucky, Massachusetts, Minnesota, New Hampshire, Nevada, New Jersey, South Dakota, Tennessee, Texas, Washington, and Wyoming. Roth IRAs can serve as college savings accounts because taxpayers are allowed to withdraw the contributions (but not profits if they are under the age of 59½) to pay for their children's (or grandchildren's) college costs without taxes or penalties. If the kids don't end up needing the money, it can be withdrawn tax-free for any reason after the investor has waited five years and turned 59½. Taxpayers can contribute up to $5,000 a year (or $6,000, for those age 50 or over) to a Roth IRA.
[Read an FAQ comparing 529s and Roth IRAs.]
4. Shop for a 529 college savings account. Residents of the four states—Arizona, Kansas, Maine, and Pennsylvania—that grant tax credits for investments in any state's 529 plan should not hesitate to compare the many options available. Savingforcollege.com has a good, free 529 web search tool. Keep in mind that research has shown that low-fee index funds that track the total stock market tend to outearn funds that charge higher fees or try to outwit the market. Alternatively, many parents prefer the simplicity of choosing "age-based funds" that gradually shift from aggressive to conservative investments as a child ages.
[Explore other online college savings resources.]
Residents of all other states and the District of Columbia should consider investing in their state's 529 plans, since the state tax breaks can save hundreds of dollars a year, says Mercer Bullard, a law professor at the University of Mississippi who has studied 529s. Funds with the lowest fees or that are age-based tend to be the simplest and safest bets.
[Why saving for college won't hurt your financial aid application.]
Several states also offer prepaid college savings plans that allow parents to lock in tuition now. While the promise of guaranteed tuition is attractive, the pledge isn't always watertight. Some prepaid plans, such as Texas's, have had to pare back payouts because their investments have not kept up with the skyrocketing cost of tuition.
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