Ask Liz Weston

Dear Liz: I have twin boys and have been looking for a college fund to set up for them. Most bank saving accounts don’t pay much interest. The only thing I have found that is halfway decent is a certificate of deposit. My grandmother set up a trust for me, but I don’t know whether that’s a good idea these days. Do you have any ideas that would help?

Answer: You’re actually asking two questions. The first is what vehicle to use for college savings, and the second is how to get a decent return on your money.

Let’s take the latter question first. Bank savings accounts or certificates of deposit are fine if your kids are headed off to college in a year or two, but these low-risk investments won’t give you much growth on your money. In fact, you’ll almost certainly lose buying power over time when you consider inflation. If your money is in a taxable account, you’ll lose that much more.

Many parents opt to take more risk in order to accumulate more funds. If college is 10 years or more in the future, investing at least some of the money in stocks or stock funds makes sense.

The vehicle you use is also important. If you expect to get financial aid, you’d be better off avoiding custodial accounts such as Uniform Transfers to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA) accounts. These were popular accounts years ago when tax rates were higher, but they count heavily against you in financial aid formulas.

Many families find 529 college savings plans to be the best choice. These state-run accounts allow your contributions to grow tax-free for college and are treated favorably in financial aid calculations. These plans typically offer a choice of investment options, including age-weighted options that start out more heavily invested in stocks but that ratchet back exposure to risk as college draws closer. For more information, visit SavingForCollege.com.

The average family starts saving for college as their child begins preschool, but only 29 percent say they are on track to reach their savings goal, according to a recent survey by student lender Sallie Mae.

Families saved an average $2,676 annually for their children’s education, for a total of $13,827, the survey found. That represents 3.6 percent of their annual household income. However, households earning under $50,000 annually set aside far more than that, saving 7.5 percent of their income, annually, for college.

The survey was conducted from March 20-April 17, 2009, by the Gallup Organization, which conducted more than 1,200 interviews by phone with parents of children under age 18. Some of the survey’s other findings:

• “529” college savings plans are gaining in popularity.  Parents with children under age 7 were twice as likely to use 529 plans (43 percent) compared to parents of teens (20 percent.) Overall, 33 percent of parents used these plans.
• 66 percent of parents said if employers matched contributions that would encourage them to save for college. Another motivator? Parents said a tax benefit (44 percent) would help them save more. (And I can’t leave this one out: 25 percent of parents said a shopping rewards program would also motivate them to save more for college.)
• Families in the Northeast saved the most with an average of $15,846. The West was a close second at $15,589. The South had an average savings of $13,722, and the Midwest had the lowest with an average of $9,693.

College costs are still increasing faster than inflation, so families who want their kids to get a head start in life should be contributing to college savings plans if at all possible. Anything you save could help reduce your child’s future debt load. For more, read:

• If you can save for college, you should
• College plans for the rich, poor and in-between
• Cram for college costs in 5 years or less
• Can colleges keep promises of aid?

Dear Liz: I would like to know how best to use a $100,000 inheritance. I am a stay-at-home mom, age 46. My husband, 42, earns $100,000 a year.

We owe $132,000 on our house and have no other debt. We pay off our one credit card in full monthly. He puts the maximum into his 401(k). We have two sons, ages 5 and 8.

Should we use the money to pay down our mortgage? I’m not interested in saving for college. We will be retiring about the time the kids are ready for college and we plan to have them take out student loans.

Answer: If you can save for college, you probably should.

College costs show few signs of moderating, so your older child might face a bill of $140,000 for an in-state public college or $200,000 or more for a private or selective public college. The cost for your younger child will be even higher. If they borrow the entire cost, they’re likely to remain financially disadvantaged for years. Students who overdose on loans often can’t save enough for retirement and delay starting families and buying homes because of their debt. Anything you save for them could reduce that terrible burden.

You also might want to rethink the idea of retiring when they start college. Even if your husband has been maxing out his retirement fund, it’s unlikely he’ll have saved enough by age 52 to last the rest of your lives, particularly if you have to start paying for health insurance on your own. (Medicare isn’t typically available until you’re 65.)

You didn’t mention savings. Most people should have an emergency fund equal to three months’ expenses, but families with just one earner typically should shoot for six or even nine months’ worth.

In any event, you almost certainly have better things to do with your money than pay down low-rate, potentially tax-deductible debt such as a mortgage.

A better approach might be to divide your inheritance into thirds, investing a third into an emergency fund, a third into your boys’ educations and a third into retirement funds.

A visit to a fee-only financial planner could help you sort through your options and clarify your goals.

To encourage participation in state-run 529 plans, the College Savings Plans Network  has declared today to be “529 College Savings Day.” They’ve got an uphill battle to promote their cause.

529 college savings plans have been under fire lately, some for good reason. Those run by Oppenheimer Funds, for example, had a too-aggressive asset allocation for students approaching college, leading to big losses. Oppenheimer also had big investments in bond funds that blew up.

That doesn’t mean you should give up on this tax-advantaged way to save for college–far from it. But you also shouldn’t invest in a 529 blindly. Here’s what parents need to know about saving for college:

Retirement has to come first. You’ve heard it before: your kids can get loans for school; nobody’s going to lend you money for retirement. However:

If you can save for college, you probably should. The more money you make, the more of your income and assets a college is going to expect you to contribute toward your child’s education. Saving early and often will help soften the shock of your “expected family contribution” and reduce the amount of debt your child may need to take on.

Don’t save in your child’s name. Custodial accounts (UGMA, UTMAs) get killed in financial aid formulas. 529s get much better treatment. Another option is to use retirement accounts, which typically don’t get factored into aid formulas, but only consider this is you’re already saving way more for retirement than you’ll actually need. Tapping your home equity should be thought of as a last resort, not your primary college funding plan. Savings is always better than debt.

529 college savings plans are a good option for many families. Withdrawals are tax-free when used for qualified education expenses, a big benefit for those in the 25% federal tax bracket. If your kids are within 5 years of college, though, the tax benefit starts to diminish: your expected returns aren’t likely to be big enough for the tax break to matter that much, and you have to put up with some restrictions on how you use the money. So if your kids are already in high school when you start saving, consider doing so in a regular taxable brokerage or bank account.

When in doubt, go with Vanguard. Vanguard’s famous for its low fees and its index-based approach to investing that aims to match, rather than beat, the markets. The Utah Educational Savings Plan Trust is a Vanguard-run option that’s Morningstar consistently names as one of the five best in the country.