Investment Strategies For Saving Money For College

Get the real deal on how to optimize your college savings.

Most parents have read the reports and heard the experts talk about the exploding costs of college tuition. From the looks of it, it seems the Gates family and a lucky handful of that caliber just may pull off sending their kids to a sub par community college, but the rest of us are out of luck.

Seriously though, while the costs are going up there's no reason to panic. For one thing, the pace has to slow down at some point, or the classes simply won't fill up. Secondly, statistics from the College Board show that only 6% attend schools that cost more than $24,000 annually for tuition - while 70% taking 4-year degrees pay only $7,000 or less.

Still, that's money that needs to be there when the time comes. How far into the future are we looking? Are junior's college years just around the corner or did he recently graduate from diapers? Nobody can accurately predict exactly what the cost is going to be decades from now, but there are plenty of free calculators online you can use to get an estimate.

Add 20% for unexpected cost increases; a lean year where you couldn't contribute and so forth, and you have your goal. Now you have to figure out how to get there. One of the easiest approaches is setting up a Coverdale ESA with a bank or brokerage. This allows you to contribute up to $2,000 a year, and the proceeds grow tax-free in an account owned by the custodian.

Another option is a Prepaid 529 plan. Basically, this is a setup where you pay a college for tuition today - to today's prices, for Junior's tuition tomorrow, when prices may have gone up considerably. The 529s come in another flavor too, the 529 savings plan, which is similar to the Coverdale ESA, except the account is owned by the student rather than the custodian.

You should discuss these options with an advisor or your accountant, but we'll focus on the options where you pick your own investments.

As with all types of investing time is your friend - more years equals more time to compound. The longer until C-Day, the more risk you can take on. Risk and reward go hand in hand, which is why stocks are risky but usually deliver superior returns, while treasury bonds are very safe but deliver modest returns. Hence, your time horizon greatly affects your investment strategy. Here are some sample investment baskets:

* 15 years to C-Day

Put 50% in an S&P 500 stock index fund, 25% in an international stock index fund, and 25% in a domestic bond market index fund. This is a simple, no-hassle portfolio that will go up and down over the years. Don't lose sleep over it - history shows lots of peaks and valleys, but you'll come out ahead in the end. Keep your cool and continue socking away according to plan.

* 10 years to C-Day

Put 40% in an S&P 500 stock index fund, 40% in a domestic bond market index fund and 20% in a muni bond fund. This mix takes some of the risk out of the equation while keeping the core relatively safe.

* 5 years to C-Day

Put 20% in an S&P 500 stock index fund, 40% in a domestic bond market index fund and 40% in a 5-year Certificate of Deposit (CD). As you add money going forward, buy 'staggered' CDs so that a year later you buy 4-year CDs, then 3-year CDs etc. so that they all mature around the right time. Also, the investment in the S&P 500 fund and bonds is only for the initial investment - any additions thereafter should go into CDs.

2 years to C-Day

Put 50% in a 2-year CD, 30% in a Treasury bond fund and 20% in a money market fund. Invest any additional deposits to the money market fund. Granted, the returns of this portfolio won't blow your hat off, but at least you know the money isn't going anywhere.

As you go from one category to the next, gradually shift over the assets to better match the new category. For example, as you go from 15 years to 10 years, put new money into bonds instead of the S&P 500 fund and you'll "grow into" the new allocation. Towards the end, you simply sell off the S&P 500 holding and transfer the money into bonds or CDs instead. Again, discuss with your advisor or accountant to fine-tune your strategy.

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