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The thought of where and when to start saving for your child’s future can be an overwhelming task for many parents, but you need not worry. In this blog, I will discuss the rising cost of college, the importance of saving now, and options for saving for college.
There’s no denying the benefits of a college education: the ability to compete in today’s job market, increased earning power, and expanded horizons. Even who your child is likely to choose as a lifetime partner changes for college graduates. But these advantages come at a price – a price that has been rising substantially. Although, many families finance a college education with help from student loans and other types of financial aid such as grants and work-study, private loans, current income, gifts from grandparents, and other creative cost-cutting measures, savings are still the cornerstone of any successful college financing plan.
The key takeaways of this blog are:
- Understanding the Escalating Costs of College
- A Focus on Savings
- College Savings Options
Understanding the Escalating Costs of College
It’s important to start a college fund as soon as possible because after buying a home, a college education might be the biggest purchase you ever make. According to the College Board, for the 2021-2022 school year, the average cost of one year at a four-year public college for in-state students is $27,330, while the average cost for one year at a four-year private college is $55,800. Many private colleges cost substantially more. Note that these calculations include tuition, fees, room, and board, plus a fixed sum for books, transportation, and personal expenses.
Though no one can predict exactly what college might cost in 5, 10, or 15 years, historically annual prices have risen between 3 percent and 5 percent. A College Board report looking at the most recent cost data predicts that the annual cost at a 4-year public university may be as high as $42,398 and as high as $86,564 at a 4-year private university for the 2020-21 school year.
Even though college costs are high, don’t worry about saving 100% of the total. Many families save only a portion of the projected costs — a good rule of thumb is 50% — and then use this as a “down payment” on the college tab, similar to the down payment on a home.
A Focus on Savings
As with any substantial purchase, the sooner you start saving, the less you have to save as your investments grow and start to work for you. Start with whatever amount you can afford, and add to it over the years with raises, tax refunds, unexpected windfalls, and the like. If you invest regularly over time, you will be surprised at how much you can accumulate in your child’s college fund. For example, if you were to invest $100 monthly with a 6% annual return, after five years you would accumulate $6,977 and after fifteen years you would accumulate $29,082. If you can invest $500 monthly with a 6% return, after five years you would accumulate $34,885 and after fifteen years you would accumulate $145,409. Note that this is a hypothetical example, and does not take into consideration fees, expenses, and taxes as well as individual portfolio performance. Note that this is a hypothetical example, and does not take into consideration fees, expenses, and taxes as well as individual portfolio performance.
College Savings Options
You’re ready to start saving, but where should you put your money? It’s smart to consider tax-advantaged strategies whenever possible. Here are some options.
529 Plans
529 plans are one of the most popular tax-advantaged college savings options. Contributions accumulate tax deferred, and withdrawals are tax-free at the federal level if the money is used for qualified education expenses. States may also offer their own tax advantages. (For withdrawals not used for qualified expenses, earnings are subject to income tax and a 10% federal penalty.)
529 plans are open to anyone, and lifetime contribution limits are high, typically $350,000 and up (limits vary by state). In 2022, lump-sum gifting up to $80,000 is allowed ($160,000 for joint gifts) with no gift tax implications if certain requirements are met.
There are two types of 529 plans: savings plans and prepaid tuition plans. A 529 savings plan is an individual investment account similar to a 401(k) plan where you direct your contributions to one or more of the plan’s investment portfolios. Funds in the account can be used to pay tuition, fees, room and board, books, and supplies at any accredited college in the United States or abroad. Funds can also be used to pay K-12 tuition expenses, up to $10,000 per year.
By contrast, the less common 529 prepaid tuition plan allows you to purchase college tuition credits at today’s prices for use in the future at a limited group of colleges that participate in the plan, typically in-state public colleges.
Coverdell ESA
A Coverdell education savings account (ESA) is a tax-advantaged education savings vehicle that lets you contribute up to $2,000 per year for a beneficiary’s K-12 or college expenses. Your contributions grow tax-deferred, and earnings are tax-free at the federal level if the money is used for qualified education expenses. You have complete control over the investments you hold in the account, but there are income restrictions on who can participate, and the $2,000 annual contribution limit isn’t likely to put much of a dent in college expenses.
Custodial Account (UTMA/UGMA)
A custodial account allows a minor to hold investment assets in his or her own name with an adult as custodian. All contributions to the account are irrevocable gifts to your child, and assets in the account can be used to pay for college. When your child turns 18 or 21 (depending on state law), he or she will gain control of the account. Earnings and capital gains generated by the account are taxed to your child each year under the “kiddie tax” rules. Under the kiddie tax rules, a child’s unearned income over a certain threshold ($2,300 in 2022) is taxed at parent income tax rates.
Roth IRA
Though technically not a college savings option, some parents use Roth IRAs to save and pay for college. Contributions to a Roth IRA can be withdrawn at any time and are always tax-free. For parents age 59½ and older, a withdrawal of earnings is also tax-free if the account has been open for at least five years. For parents younger than 59½, a withdrawal of earnings — typically subject to income tax and a 10% premature distribution penalty — is spared the 10% penalty if the withdrawal is used to pay for a child’s college expenses.
A Word About Financial Aid
Many families rely on some form of financial aid to pay for college, which may include loans, grants, scholarships, and work-study. Financial aid can be based on financial need or on merit. To determine financial need, the federal government and colleges look primarily at your family’s income.
To get an idea of how much grant aid your child might be eligible for, you can use a net price calculator on almost every college website. The bottom line is to beware of too much borrowing to pay for college. Excessive student loan debt — and parent debt — can negatively affect borrowers for years. The more you save now, the less you and your child will potentially need to borrow later.
The Bottom-Line:
Start as soon as you can with as little as you can. The benefits of compounding interest will reduce the debt necessary for you and your children.