Use an online financial calculator that includes inflation adjustments from now until the year a child enters college and time value of money factors to determine how much savings is required. Then, decide how much of this cost is realistic to save on an annual and monthly basis (for example, $40,000 in 16 years = $2,500 a year or about $208 per month).
Match your college savings and investments to your time horizon. College savings may be a short-term goal (less than three years), a medium-term goal (three to 10 years), or long-term goal, depending on your children’s ages.
For time horizons of eight to 10 years or more, stocks and stock mutual funds have historically provided the highest return of any type of investment and are often recommended for college savings for children in elementary school and younger. Once a child enters middle school, assets should be gradually shifted into fixed-income (such as short- and intermediate-term bond funds) and cash (such as money market mutual funds) assets. By the time a child is a college freshman, most, if not all, of the money saved for college should be reallocated.
Many state 529 college savings plans provide investment options with age-based asset allocations that grow more conservative as children get closer to college age (for example, 100 percent in stocks at age 3 and 60 percent at age 10 in one state). Asset class weightings vary from state to state, however, and need to be studied closely and compared.
Take advantage of available tax breaks for college expenses, including the Hope Scholarship Credit and the Lifetime Learning Credit. Each one has rules concerning how it can be used in combination with other tax breaks. For example, in the year you claim the Hope Scholarship Credit, you may not claim the Lifelong Learning Credit. Before deciding to use a particular tax break, check to see if there is another one that would provide more benefits and how one tax break affects another.
When investing in tax-advantaged 529 plans and Coverdell Education Savings Accounts (ESAs), contributions grow tax-deferred and withdrawals are free from federal tax if used for qualified education expenses. Get advice from a college financial aid office or tax preparer, when needed.