Building a college fund: Finding courage to take the first step may be the biggest hurdle

Parents looking to stash away money for both college and retirement can find themselves caught in a giant tug-of-war.

Do you make the sacrifice to fund a child's college education and worry about retirement later? Or do you assume that you'll find a way to cover college costs with loans or scholarships and focus on your own future instead?

"Often I find young families struggling with the issue of saving for retirement or saving for their children's college," says Kelly Darby, a financial representative with Modern Woodmen of America. "Through a proper needs analysis we can create plans that accomplish both aspects for the parents given the age of the family. It is possible to save for both on a limited income."

Maximizing savings now, for both retirement and college, is far preferable to planning a future built on student loans.

"Every dollar (you borrow) will cost you two, on average, by the time you finish paying off a loan," says Mark Kantrowitz, founder of college-cost resources Finaid.org and Fastweb.com. "When you're saving, you're keeping the interest. When you're borrowing, you're paying the interest."

Most experts agree that, if possible, you should save for both, early and often, particularly given the rising cost of tuition. The College Board found that college costs increased 26 percent in the past five years, an average that includes both four-year public and private schools. Parents have not been able to keep up. They were projected to meet just 16 percent of college costs in 2011, down from 24 percent in 2007, according to Fidelity Investments' fifth annual College Savings Indicator Study, released in August 2011.

But the Fidelity study also found that parents are changing their savings behavior. Some 40 percent of parents with children younger than 5 started saving for college costs in a dedicated account, up from 27 percent in 2007.

"The sooner the better," Darby says of saving for your child's education. "When time is on your side, you can better plan how you will handle future setbacks. A lot of my clients begin the process of saving for their child's college as soon as the child is born. The longer you wait to begin a systematic savings plan, the more money it will take to accumulate the funds needed. With all of that said, it is never too late to start saving and each situation is unique."

For those who want to figure out how much they might need, Kantrowitz suggests setting a goal of one-third of expected college costs. "If you focus on the full amount, you'll feel overwhelmed and you may not even get started," he says.

Darby says to base the goal on the college the child chooses in the future.

"It is very difficult to get somewhere if you do not know where you are trying to go," she says. "College costs for the future do not go down; rather, they increase over time and as we have seen over the last few years they are rising faster than inflation. I advise clients to consider these issues when deciding the appropriate goal for their college savings program. At the very least, a parent should review the effects of inflation on the value of money in the future to determine the average cost of the college savings they should put back."

And, she says, leave room for error. "You cannot go back and change the amount of money you chose to save, and no one truly knows what will happen in the future to inflation," Darby says. "It is better to have too much money than too little."

She says a good place to start is using a calculator, like Modern Woodmen's College Savings Planner, that will take into account the current inflation of education costs of about 8 percent. It can help you calculate the amount you would want to save monthly to meet the goals.

Once a goal is in place, you can explore savings options. There are several factors to consider, according to Darby: The effect of how the investment will be taxed and also the access to the funds. "Are there any penalties at the attained age they will need the funds or are there any tax consequences associated," she says. "They would of course want to consult their tax adviser about the tax issues."

She says putting a system of saving in place is the biggest challenge. "The biggest hurdle a family faces saving for college is discipline to put back the funds each and every month," Darby says. "Once a system is in place, it is easy to continue the process of saving and creating the mindset that this is important."

-- Content That Works contributed to this report.

College saving plans

"Families are planning earlier and saving more efficiently, yet saving for college will continue to be a challenge," says Joseph Ciccariello, a Fidelity vice president.

Here are some key ways to invest college funds wisely:

Coverdell Education Savings Account allows families to contribute up to $2,000 per child per year. There are income limits. Like an individual retirement account, a Coverdell account can be invested in stocks, bonds, mutual funds, certificates of deposit or money market funds. As the money grows, you are allowed to defer paying federal income taxes. In many states you will not have to pay state taxes, either. You can withdraw the money tax-free for educational expenses at any time. This program, however, is best for individuals with modified adjusted gross income of less than $95,000, if single, or $190,000 for those who are married and who file taxes jointly.

State-sponsored 529 college savings plans, available to families of all income levels, offer much higher contribution limits. Investors select from a platter of mutual funds and other investments. Earnings are tax-free as long as the money is used for qualified education expenses. While 529 plans have proved popular, returns are not guaranteed. Declines in the value of 529 plans are unsettling to families, especially when students are nearing college age. States have added more conservative options to the plans, adding FDIC-insured certificates of deposits, savings accounts and age-based accounts that trim back stock investments in favor of less volatile options as children age.

Prepaid 529 college savings plans, the first cousins of 529 plans. They allow state residents to pay now to lock in prices at a state university. A premium over the current tuition rate is factored in to cover future tuition inflation. Some states have programs that allow families to buy a fixed number of tuition credits at today's prices. It's important to read the fine print on prepaid 529 plans to understand how or if your state will handle a shortfall in the event the plan's investments do not deliver expected returns. Some states have suspended or closed their plans after financial difficulties.

-- Content That Works