Educating Your Children without Going Broke

Just about the time a chiropractor's practice is thriving and college loans are paid off, the doctor may be faced with the challenges of raising a family. One primary concern of young families is educating your children without going broke.

When your children are ready for college, will you be ready to send them? With college tuitions across the country rising year after year (and rising faster than the general inflation rate), the sooner you begin a monthly or yearly investment program, the more confident you can be that the money will be there. Here are some ideas to think about and discuss with your financial advisor.

A Special Account for Each Child

In the past, parents could set up a custodial account to invest for a child's education almost tax-free. The Tax Reform Act of 1986 has restricted the tax advantages somewhat, but a custodial account under the Uniform Transfers to Minors Act is still worth looking into.

If your child is under 14, annual investment income (dividends and/or interest) up to $600 in a custodial account will be tax-free; another $600 will be taxed at the child's lower rate, with the excess over $1,200 taxed at your rate. After your child reaches 14, all investment income is taxed at the child's rate.

Investments from which the income is tax-free need not be in a custodial account since they already enjoy special tax treatment. If you want to maintain control of the assets, you can set up an account in your name earmarked for college funding.

Slow but Steady Wins the Race

If you have the chance to set up a college-funding account when your child is born, then it's easy to use this rule of thumb: For each year of the child's age, make sure the account's value is at least five percent of the current cost of the kind of education you want to provide. For example, if the current cost of four years at the school you have in mind is $40,000 (be sure to include all costs: room, board, tuition, and expenses), and your child is six years old, the account's current value should be at least 6 x 5 percent x $40,000 = $12,000.

If you're starting later, you need to accelerate the process. If your child is eight or 10 years old before you start a college fund account, keep an eye on college costs with a view to putting 10 percent of current costs into the account each year.

Perform this calculation each year. If the account is keeping up with college costs and your child's age, pat yourself on the back. If it's not, you can work with your financial advisor to make up the shortfall with any of the following kinds of investments, among others:

High-Quality Stocks

The prices of stocks, of course, go down as well as up. But well-chosen stocks offer the opportunity for excellent long-term growth. In fact, stocks and stock mutual funds (discussed below) are the only types of security that have consistently beaten inflation over long periods.

You can make the ups and downs of the market work for you through an investment discipline called dollar-cost averaging. The idea is to invest the same number of dollars every month (or every quarter, or every year), whether prices are currently high or low. The result is that you buy fewer shares when prices are high, more shares when prices are low. Over time, your average share price is likely to be lower than the average price of the stock over the same period.

Of course, you're still betting that the average share price when you sell will be significantly higher than the average price you paid. That's why it's important to choose high-quality stocks -- stocks whose prices represent good fundamental value and are likely to move up strongly over the long term.

Mutual Funds

Mutual funds investing in stocks can be a good long-term choice for college accounts. Here again, prices move up and down, so quality is important. Each September's first issue of Forbes is a special issue devoted to mutual funds. It includes the Forbes Honor Roll, which lists funds that have established good long term results in both bull and bear markets.

Again, dollar cost averaging can be a smart way to invest. You should also look for a family of mutual funds, to allow diversification as your portfolio grows.

Zero Coupon Bonds

Zero coupon bonds (also known as "zeros") are nothing more than a traditional bond with no interest payments. Rather than a semi-annual coupon, zeros are purchased at a deep discount and then repaid at par upon maturity. Although zeros are most often U.S. Treasury zeros, the zero coupon bonds can be any form of interest paying bond, including tax-free municipal bonds. These bonds compound at a predetermined rate of interest on a semi-annual basis until maturity.

As an example, a seven percent zero with a 20-year maturity will currently cost $2,525 and will repay $10,000 at the end of the 20 year period.

You can select maturity dates in each of the four years when tuition will be needed. With most zeros, the interest is taxable each year, although you don't receive it until maturity. However, zero coupon bonds on which the accumulating interest is tax-free are also available.

Municipal Bonds

Municipal bonds pay interest exempt from federal taxes, and often from the taxes of the state in which they are issued. You can buy a bond (ordinarily for the face value of $5,000) and have the interest payments accumulate tax-free until the face value is paid back at maturity.

Variable Universal Life Insurance

This new form of life insurance combines four important advantages into one plan for college education funding:

• mutual fund investments (stock, bond, money-market, international, and balanced funds) that grow tax-deferred;

   

• access to your earnings before age 59 and 1/2 -- without income taxes or early withdrawal penalties;

   

• monthly, quarterly, or semi-annual dollar-cost averaging -- through direct withdrawals from your checking account, if you wish;

   

• tax-free death benefit through low-cost term insurance.

Rule #1: Don't wait. Whatever your child's age, the time to prepare for college expenses is now. Talk with your financial advisor today.

Michael Vopatek, financial consultant
Vienna, Virginia

Editor's note: Questions may be directed to Mr. Vopatek at 1-800-925-3308.