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If you're planning to send your kids to college, it's never too early to start saving. Fortunately, there are some excellent investment options designed specifically for college savings that can help you grow your money and give you some tax advantages as well.
If you're not sure where to start, here's a quick guide to getting your child's college fund up and running.
1. Decide what type of account you need
There are a few different ways you could choose to save for college, and here are three of the most common:
529 Savings Plan -- These accounts are run by the states, and may be opened directly or through a brokerage. A 529 savings plan allows you to contribute money, invest in mutual funds similarly to a 401(k), and withdraw money tax-free for qualified higher education expenses. Contribution limits are high, and your state may offer additional tax incentives.
Coverdell ESA -- Similar in tax treatment to a 529, a Coverdell has a few key differences. The main drawback is that you can only contribute $2,000 per year for each beneficiary. However, you can invest in any stocks, bonds, or funds you want, and can use the money for any level of education,not just college.
Roth IRA -- Although a Roth IRA isn't specifically intended for college saving, it can be a useful alternative if you don't want to commit to using the money for college expenses. Specifically, there is an exemption that says Roth IRA funds can be withdrawn penalty-free anytime to pay for college expenses.
Here's a more thorough look at these three account types to help you decide.
2. Research account options
If you choose a 529, you have a lot of options -- you aren't limited to your own state's plan. However, I mentioned before that a lot of state-run plans offer incentives to residents, so it's a good place to start. There's a great directory at www.savingforcollege.com that you can use to compare your home state's plan with others.
If you choose one of the other options, it's a little easier. Coverdells and Roth IRAs are available from a wide variety of online brokers, and opening an account is rather easy.
3. Invest through a broker or buy direct?
This step applies to 529 plans only. While the options available vary by state, I'll use my home state of South Carolina's 529 savings plan as an example. There are two options -- direct-sold and advisor-sold. The direct-sold option can be opened, funded, and managed directly through a state-run website, but is only available to state residents.
On the other hand, savers who want to invest in the plan but aren't state residents have the option to invest through a financial advisor. Other states, such as Tennessee, will allow anyone, regardless of residency, to directly invest in its 529.
Additionally, many online brokers offer certain states' 529 savings plans. For example, TD Ameritrade's 529 savings plan is sponsored by the state of Nebraska, and is open to all U.S. college savers.
4. Decide on your investments
In a 529 plan, the investment options look similar to those in a 401(k). There are a variety of stock- and bond-based investment funds to choose from, with varying levels of risk. There are also pre-packaged portfolio options designed for a specific risk tolerance (aggressive, conservative, etc.) as well as target-date funds that gradually shift from aggressive to conservative investments as your child gets closer to college age.
If you choose a Coverdell or Roth IRA, it's not so simple, thanks to the choice between thousands of investment options. However, it doesn't have to be too difficult -- our Foolish contributors are here to help you choose solid investments for either of these account types, whether you want to invest in mutual funds or individual stocks.
5. Fund the account
You'll have several options to fund your new account. You can deposit a lump sum when you open the account, or you can deposit a little bit at a time. Or, you can set up automatic contributions to occur weekly, monthly, quarterly, or at another interval. Many savers use a combination of these options -- as a personal example, I prefer to contribute large amounts to my kids' 529 plans every few months, while my wife has a smaller contribution set up to automatically transfer from her checking account every payday.
6. Do periodic maintenance
If you choose a target-date investment strategy, you can literally just deposit into the account and leave everything alone until your child is in college.
On the other hand, if you choose other investment funds or invest in individual stocks and bonds, there's one important homework assignment you have. As your child gets closer to college age, you need to gradually change your strategy from a growth-oriented one to a preservation-oriented one. Simply put, this means gradually shifting from stocks to bonds (and even some cash assets) over time. You don't need to make changes every so often -- every couple of years, simply increase the percentage of your portfolio in less-risky assets by 5% or so, and you'll be fine. Here's a thorough discussion of asset allocation that explains this concept in detail.
7. Watch your money grow
The final piece of advice I'll give is to leave your money alone once it's invested. Aside from shifting your asset allocation as I described in the previous step, it's generally a good idea to leave your investments alone. This is an especially important concept if you choose a Coverdell or Roth IRA and buy individual stocks. Don't try to be a "trader" with the account -- just let your investments do what they're supposed to do. There are some situations where it's OK to sell stocks, but you should approach your college investments with the intention of holding onto them until you need to withdraw the money.
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