Paying for college as an adult

I'm getting married in a few weeks to my college sweetheart, Michelle. Currently, she's working for NPR, teaching a film class, and going to grad school. I work for a government contractor doing various types of IT consulting, project management, and technical writing. We're trying to make decisions about how to pay for her grad school that won't put us in the poor house, which is easier said than done, considering the interest on student loans for our generation is sometimes more than double the rate that my GenX friends are paying.

Michelle took out loans to pay for her first year of grad school because that was her only option at the time. But now, a year later, we're both a bit more settled and have stable careers and a little extra income each month. She's in a three-year program, so we've got a bit more financing to do, giving us a few options to churn about. Should we:

1. Take all of our extra income and pay it toward her current loans?
2. Put it into a savings account and pay cash in August when her next tuition bill comes due?
3. Save our money, continue to take out loans, and hope we have enough cash when she graduates to pay off a substantial portion?
4. Utilize a more creative strategy?

We chose number four. After doing some research online, we decided to do two things with the disposable income we're able to dedicate to her education expenses:

1. Save enough in a high-yield savings account (E*Trade is what we use) to pay the accrued interest on her current student loans
2. Put the rest of our dedicated $$$ into North Carolina's 529 plan

Here's our logic:
Since interest rates on graduate loans are in the 8% range, we certainly don't want to increase the principal on which we pay interest if at all possible. I mean, the interest alone on a year's worth of student loan debt comes to over $100 per month. While she's in school, payments are deferred, but interest still accrues. We get our quarterly interest statements and are damn sure to pay every penny of it. Albert Einstein once said, "The most powerful force in the universe is compound interest." You certainly want the most powerful force working for you, not against you! By letting that interest build up over the years she stays in school, the total cost of her college would increase significantly.

After paying her student loan interest each quarter (which is usually a few hundred bucks, never more than $500 I don't think), we figured out how much more we could contribute toward her college expenses (around $250 per month). All of that money has been placed into a 529 plan. Here's why:

The account's funds, which may only be used to to pay only for the named beneficiary's college tuition and related expenses, has tax benefits which are two-fold (depending on which state you're in). In the state of North Carolina, contributors may write off up to $2,500 in contributions from their state taxes. Additionally, the investments in the plan grow tax free, as long as the money in the plan pays for qualified college expenses (sorry, beer and pizza aren't qualified).

529 plans are to college as Roth IRA plans are to retirement. Only after-tax money is contributed, but as long as it's used for its intended purpose, that money is never taxed again. The risk that you run with 529s is that the beneficiary never goes to college. With Roth IRAs, you run less risk because you're only betting that you're part of the human circle of life and will reach the qualified retirement age before you die (and if you die young, who cares about the money?). The nice thing about putting money into a 529 plan for someone that is about to start college or has already begun is that the risk of them not attending is significantly mitigated.

To recap the benefits of our college financing strategy, consider this:

1. All of the money we have saved for Michelle's college is growing tax free
2. Up to $2,500 of her out-of-pocket college expenses are tax-deductible (again, this depends on your state)

To read more about 529 plans, click here