First, set a specific, realistic goal for the amount you need to accumulate. You can use Decision Center's Tuition Savings calculator to help.
Your strategy also depends on your specific situation. We've identified several typical scenarios. Choose the one that best describes your situation.
1.
I have a large sum to invest for at least 12 years.
2.
I have a large sum to invest for about eight to 12 years.
3.
I plan to make regular contributions in small amounts for at least 12 years.
4.
I plan to make regular contributions in small amounts for eight to 12 years.
5.
I plan to invest both a start-up sum of $5,000 or more and make smaller contributions for at least 10 years.
6.
There are about five years left before my kid starts college.
7.
There are only two years or less before my kid starts college.
1. I have a large sum to invest for more than 12 years.
If you have a large sum to invest and a substantial period of time before your child goes to college, you can consider a non-callable long-term bond. It doesn't offer the highest total return, but you'll take care of college once and for all.
Zero coupon bonds are the most common types of these investments. They're tailor-made for the long-term investor who doesn't need to use the interest. Zeros have all the characteristics of other bonds, except that the interest-bearing coupon has been stripped from it. It's sold at a discount (at an amount below face value or par). In general, the longer you're prepared to tie up your money, the more the discount. At the maturity date of the bond, you'll receive its full face value. The difference between what you paid and the face value is your profit.
You'll pay taxes each year at your ordinary income rate. But, if the bond is in your child's name, $1,300 of any gains will be tax exempt until he or she reaches age 14. At that time, the child will have to report income separately.
2. I have a large sum to invest for about eight to 12 years.
With a decade or so in which to invest, your stock choices must be more strategic. Consider the Dow Dividend Strategy, which buys the 10 Dow Jones Industrial stock with the highest yields in relation to their price. Several funds invest in these so-called "Dogs of the Dow."
Some include Treasuries for safety, others add selected non-Dow stocks, while still others invest half in the Dow Dividend Strategy and the other half in the S&P 500. A unit trust called Select 10 holds only the Dow 10 and readjusts six times a year to insure that all stocks meet the strategy's requirements.
3. I plan to make regular contributions in small amounts for at least 12 years.
If the amounts you plan to invest are small and recurring, a disciplined investment plan called dollar-cost averaging in the stock market is the answer. With dollar-cost averaging, you choose your investments and contribute the same amount month after month. The cost of the stock or mutual fund will average out to be less than a one-time lump-sum investment.
With more than 10 years and as many as 16 years to build a tuition nest egg, you can work dollar-cost averaging into several of the strategies that get you into the stock market as a whole. For example, a $1,200 yearly investment ($100 a month) that pays an average annual rate of 10 percent will accumulate to $60,191 in 18 years. That's enough for most colleges, especially if it's supplemented with a small loan and/or scholarship.
Historically, index funds, like the S&P 500 or unit investment trusts on the American Stock Exchange called "spiders," allow you to meet that 10 percent return. With several years to invest, you're well positioned to wait out market downturns.
4. I plan to make regular contributions in small amounts for eight to 12 years.
With a half-decade before your child starts college, you, too, can use the dollar-cost averaging system mentioned in the section above. It allows you to contribute a set amount of, say, $100 a month, into a portfolio of stocks and bonds. The difference is that since you have a little less time to invest, you still want to emphasize growth but you may want to moderate your risk a bit by shifting some assets into income funds.
Therefore, your more conservative growth portfolio might include about 30 percent in a growth fund invested in quality companies, 30 percent in growth and income funds and 40 percent into something more conservative, such as an intermediate-term corporate bond fund.
5. I plan to invest both a start-up sum of $5,000 or more and make smaller contributions for at least 10 years.
If you are lucky enough to be able to do both dollar-cost averaging and contribute a lump sum, invest based on the number of years before school starts. Look at the sections in this article based on the number of years you have to invest. Just combine the safety net of bonds with the returns of dollar-cost averaging in the stock market.
If you give as a gift a lump sum of several small amounts, be aware of the gift-tax consequences.
A gift that is already made is a legal transfer. Once made, it is not your money anymore. Only if you act as custodian do you have the right to manage the investment and distribute the funds. The simplest custodial accounts are the Uniform Gifts to Minors and the Uniform Transfers to Minor accounts.
With both accounts, you, as custodian, control the use of the money, without any court intervention, until the child reaches adulthood. This can be anywhere from 18 to 21 years old, depending on state law. At that time the money comes under the child's control. Until then you are a fiduciary.
When you make any gift, be prepared to deal with the Internal Revenue Service. If the gift exceeds $10,000, you must file a gift tax return by the April tax day after the year in which you gave the gift. If you want, you can pay no tax and deduct the gift from your lifetime exclusion of $600,000. Even an exempt gift triggers a filing, if you and your spouse give a joint (often called a split gift) donation. There will be no tax if the total gift is $20,000 or less, but you still must file.
Gifts to a trust count as a gift to the beneficiary and are added to the yearly total to determine your qualification for exemption.
Receipt of a gift of $10,000 or more from a foreign donor requires a filing by the recipient.
6. There are about five years left before college starts.
With only five years to invest, you'll either have to make a hefty one-time contribution or sizable regular donations to pay 100 percent of the tuition. The reality is you probably won't do either, so you might want to start considering what loans (such as home equity loans or low-interest student loans) you can get. From an investment standpoint, if you decide on a low-risk, A-rated bond, a certificate of deposit or an income mutual fund, the best return you can expect historically is about 8 percent. At that rate, you'll need a lump sum of nearly two-thirds of your goal to hit target.
To increase returns and minimize risk, allocate the lump sum into several asset categories and use mutual funds that fit each one. For example, a recommended mix is: 30 percent in a growth fund, 20 percent in a balanced fund investing in stocks and bonds, 30 percent in an intermediate-term corporate bond fund, and 20 percent in short-term bonds or certificates of deposit.
If you're going to use a regular contribution strategy, stick with lower-risk products such as bonds, CDs or money market accounts.
7. There are only two years or less before college starts.
If you're beginning to invest just two years or so before your child goes to college, you must sacrifice the possibility of stock market gains for the certainty of "targeted" investments especially designed to pay for college.
The College Sure is a certificate of deposit that puts you on a targeted plan, with either a lump sum or monthly contributions. You're assured that you can pay for a designated number of semesters, even if prices go up in the next two years.
The Baccalaureate Bond, similar to zero coupon bonds but specifically designed for college planning, may work if you have a lump sum. Only about 20 states issue baccalaureates. To use them you must be a resident of the state and your child must attend a state university. They work like any other tax-free zero bond except that your state will give you a discount on tuition if you enroll in the state university and pay with these bonds.
Take care to buy this type of bond only if your child will definitely go to the state school and if the bond rating is investment grade.
If you have only one or two years left before college and financial aid is a possibility, you may be better off making no investments at all. The likelihood of your money growing to any great extent is offset by the possibility that you will defeat any chance for financial aid, grants, loans and certain scholarships. 