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child's backpack full of money
Bill Diodato

When putting away money for retirement, you probably have a pretty good idea of the basics: Start early, pick a balanced, low-cost portfolio of stocks and bonds, and aim to spend it down judiciously over time. But when you turn to what's probably your second-biggest investing goal—funding your child's college education—the challenge gets far more, well, challenging.

As with retirement, you have a big nut to come up with: The sticker price on a four-year education is now $176,000 at a typical private college ($78,000 in state at the average public school), according to the College Board. And it could be more than $400,000 for private college by the time today's newborns turn 18.

But unlike the case with retirement, your investing time frame is much shorter, both for amassing the funds (18 years, vs. 30 or 40) and for spending them down (four to six years per kid instead of decades). "It's like the difference between landing a plane at an airport and landing on an aircraft carrier," says New York City financial planner David Mendels.

That requires a Goldilocks investment approach that is hard to get just right. You want a hefty helping of stocks, particularly when kids are young, to generate growth, but enough bonds later on to ensure that your money is intact when you need it. Go too heavy on risky assets at the wrong time, and face big losses—as some parents discovered during the financial crisis, when the supposedly conservative plans they had set up for their teens fell as much as 30%, according to Morningstar. But if you gorge on bonds, your savings will fall short; while tuition inflation has eased over the past decade, even the more modest 5% increases are higher than recent returns on a typical bond fund.

So what's a parent to do? To get where you have to go, you'll need to max out your tax advantages, pick a smart portfolio approach, and resist the temptation to put it all on autopilot. Here is a step-by-step investment plan to follow, from diapers to freshman dorm.

Put tax breaks to work

College investors have one key thing in common with their retirement counterparts: access to a tax-advantaged account that can amplify savings growth. In a 529 savings plan, your investments grow tax-free and can be withdrawn tax-free, as long as the money goes to tuition or other qualified higher-education costs, like books or housing.

Nearly every state sponsors its own 529s, with different investment options and, in some cases, tax breaks that supplement federal tax benefits. Most common are state income tax deductions, although a few offer tax credits. You can shop around for a plan with the best combination of investment offerings and low fees—but by going out of state, you may lose any tax breaks available to residents.

The first decision for parents, then, is to pick the right plan—which in turn means weighing the quality of the investment options against the tax benefits you might earn by staying in state. "Not all plans are created equal," says Dublin, Ohio, financial planner Mark Beaver.

Bill Diodato

You have a broad menu of investment options. Almost every state has a prepackaged, age-based portfolio that shifts over time from a heavier stock allocation to more bonds and cash; in most cases this should be your starting point. About half of age-based plans also let you vary your risk level, choosing more conservative or aggressive approaches. And almost every state has some do-it-yourself options, although choices range from plain-vanilla index funds to actively managed funds. Plans generally let you move your money among different options, so these à la carte choices can be a good way to tinker around the edges of your account. If you're going it alone, be aware that you can switch allocations only twice a year.

There are also adviser-sold 529 plans—but if you're not working with an adviser already, don't seek one out for this purpose alone. You'll wind up paying extra to get the adviser's services, says Andrea Feirstein, a 529 plan consultant: "The extra cost eats into your returns."

When deciding whether to stay in state, use the rule of thumb offered by Morningstar analyst Janet Yang: If the tax benefit is worth more than 5% of your initial investment, it typically trumps the costs of even an expensive plan. In that case your best bet is to stay put.

To run the numbers yourself, start by figuring out the dollar value of your state's tax perk. If your state taxes income at, say, 5%, but caps the deduction at $2,000, the tax savings for a $2,400 annual contribution—$200 a month—would be $100. Then compare that figure against your total contribution; in this case the tax benefit is 4.2%.

For instance, Indiana offers in-state investors a 20% tax credit on up to $5,000 in annual college savings. The plan's fees are comparatively high—0.49% on the option designed for small children, more than twice what the cheapest plans in the country charge. But for Hoosiers it's the best deal going, Yang says: The tax benefits are "too generous to ignore."

You should also stay in state if your state has a tax benefit that's at or below 5% but your state's plan is a winner.

By contrast, if you live in a state that offers no tax perks (or has no income tax)—or is one of the six that delivers tax benefits no matter where you invest—you might as well shop around for a plan with a good slate of investment options and low costs. The Utah Educational Savings Plan, administered by index fund giant Vanguard, has among the lowest fees in the country and gets top marks from both Morningstar and Savingforcollege.com, a website that rates plans. Others that get gold stars from Morningstar—with low fees, solid track records, and well-regarded parent companies—are Alaska's T. Rowe Price College Savings Plan, the Maryland College Investment Plan (also run by T. Rowe), and Nevada's Vanguard 529 College Savings Plan.

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The math gets trickier in a handful of states, including Louisiana, New Mexico, and Mississippi, that offer middling tax benefits but lack an outstanding plan. In general, while your children are young (under 10, say), your best bet is to invest in the lowest-cost plan, according to Yang. Once you're investing for a teenager, however, reach for the tax perks.

That's because while the tax benefits kick in the first year you make the investment, that's a one-time benefit. Over time, high fees will act like a drag on your investment, sapping returns. So a 2.5% tax break is like getting a 2.5% bonus in the first year—but as the years go by and investing costs play an increasingly important role, that bonus gets diluted. The same thing happens every year. By year 10, the tax benefit is giving an annualized boost of just 0.19%, according to a Morningstar analysis that assumes 6% returns.

One final thing to keep in mind: When setting up the account, title it in your name. That way, colleges will count the money as a "parental asset," meaning those dollars will lower your child's potential financial aid by a maximum of 5.64% a year. An account in a child's name, by contrast, would be assessed more severely, at 20% a year.

Sprint out of the gate

With plenty of years to ride out market swings and capture the benefits of compounding, this is the best time to get a jump on future college costs. So as a brand-new parent, you have three key goals to aim for: Start immediately, put aside as much as you can manage, and load up on stocks.

The average age-based 529 plan starts off for newborns with about 80% invested in stocks, according to Morningstar; aggressive options average almost 90%, but conservative ones have just under 50%.

At this point a conservative approach carries its own risks. Many 529 plans started offering these options after the 2008–09 crisis, when investors panicked and pulled out funds at the market bottom, explains Mark Kantrowitz, author of several books on scholarships and financial aid.

Yet research shows some of the downsides of playing it too safe. A study by Vanguard assumed that a college saver invested $1 a year, adjusted for inflation, each year for 18 years; it then ran market simulations to gauge the impact of various allocations. Investors in the aggressive track, which starts with 100% in stocks and introduces bonds in year four, ended up with a median $37 across the different scenarios. Conservative investors ended up with a median $26.

What was surprising: The most conservative investors were also the most likely to finish the simulation with $18 or less. Over the 18-year time frame, stocks' superior earning power simply tended to make up for any losses.

While most parents are best off using an age-based plan at least as a foundation, there are a handful of exceptions. You may want to be even more aggressive, for instance. Some advisers and analysts suggest starting out with a 100% allocation to equities if you have the temperament to ride out big market swings.

Fees can be another key factor. Virginia residents, for instance, should stay in state to get the generous $4,000 tax deduction. But the state's most aggressive age-based plans charge investment fees of 0.65% to 0.73% a year because they use active stock pickers. So Virginia residents could slash costs by creating their own allocations using the plan's à la carte menu of index funds.


Shift gears for tweens

Once your kids enter their second decade, it's time to recalibrate. You still need stocks for growth, but you'll want to shift at least some money into bonds for stability.

How much should you pull back? Check your account statements for a gauge. You may be ahead of the game—perhaps you've been saving a ton, or maybe you've gotten a boost from a booming stock market or a surprise gift from a grandparent. Like some parents of tweens now, you might even be casting a nervous eye at equities as the stock market gyrates.

If you're doing well, shift more money out of an age-based portfolio and into bonds. "Capitalize on the gains you've made," says Walpole, Mass., financial adviser John R. Power. "You're in good shape."

Yet a more likely scenario is that you still need to try to earn as much as you can. If so, the benefits of being at least somewhat aggressive still outweigh the risks. "For a lot of people, the risk you won't get there in the first place is bigger than the risk that the market will go down," says Mendels.

Morningstar's aggressive portfolio recommends 80% in stocks for 10-year-olds. At this point "it makes sense to be a little more aggressive," says David Blanchett, the researcher at Morningstar's investment management arm who helped develop its recommended glide path. After all, Blanchett says, college has one fail-safe that retirement doesn't: Even though you should never plan to borrow heavily or tap your other savings to cover a shortfall, you'll still have that option in a pinch.

Note that you'll still need the stomach to ride out a bear market; those 20% declines take place almost every five years, on average. And remember, because of the trading restrictions, you can't expect to game the market by jumping out of stocks at the first sign of trouble. Then again, a 10-year-old has roughly a decade before most of the money needs to be spent, and while stocks can be volatile, they also have tended to snap back quickly. In the worst five-year stretch since the Depression, 1970-74, stocks finished down only about 2.4% a year, according to Ibbotson Associates. Over 10-year periods after the 1930s, they've never lost money.

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Most age-based 529 plans have already made some adjustments. But because there is a huge variety of approaches, this is a good time to make sure your plan is behaving the way you want it to. For example, Iowa's plan—a top pick for residents of that state thanks to a tax break that could be worth nearly 9% of your investment—still has 100% in stocks at age 10 for those on the aggressive track. By contrast, Michigan's aggressive version has already cut stock holdings to 75% by this point. And T. Rowe's Maryland plan, which offers just a single age-based option, is still more conservative, with 65% equities for 10-year-olds.

If your automated plan's allocation seems wrong for you, don't be afraid to tweak it. If you're in good shape but you're using an aggressive path, check whether your state's plan has a more conservative allocation. If you're behind and your age-based plan has only 65% in equities, you could move some money into an index fund to bring your stock allocation higher.

This is also a good time for a reality check on your savings goal. Don't panic if you're falling short, Kantrowitz says: "You don't need to save the full sticker price." A good rule of thumb? Aim to cover a third of the projected cost out of your investments, borrow a third, and pay for the final third with any aid grants plus your salary at the time.

Ratchet down risk

For the final years of high school, your 529 portfolio needs to get far more conservative. By the time your child is 16, you will want to have cut equities to 20% to 30%, with the balance moved into bonds and cash. Once again, check your age-based account to make sure that it's in line; if it's not, shift a portion of your 529 funds to get a more conservative allocation or add a separate money-market or bond fund.

"It's important to track your mix," says Pewaukee, Wis., financial adviser Kevin Reardon. "If you aren't paying attention, you could end up too aggressive."

Remember that Vanguard study? One of the few scenarios in which conservative investors—with 100% in bonds and cash in the final years—ended up better off was when there was a massive market plunge in the last two years before a child went to college.

Reardon suggests looking at least two years ahead. By the time your child is a junior in high school, have enough money in cash—not just bonds, which can suffer principal losses if rates rise—to cover your expected withdrawals for the first year of college. The following year, double that cash pile. "You'll be confident you can ride out most downturns," he says.

Until your child enters school, don't abandon stocks entirely. Despite the risk, you need to keep up with rising prices. A portfolio with 20% in stocks, 50% in cash, and the rest in intermediate-term bonds would have lost only 6% in 2008.

Once your child is in school, you can move everything to cash and start spending down the balance. Your aim is to have no money left over—unless you're ready to start saving for the grandkids.