Saving for college is one of the biggest financial priorities for most families—and also one of the hardest to meet, given the huge cost. Let’s take a look at our many options so we can create a solid plan for our kids’ education.
How Much to Save for College
With so many other financial goals—including paying off debt, saving for emergencies, investing for own retirement, and caring for our aging parents—it might seem impossible to also save for our kids’ college education at the same time. (There’s hardly any room for fun much less textbooks and tuition.) You only need to look at one graph to see how the cost of a college degree has been skyrocketing and how it far outpaces the median household’s salary:
Today, the average total cost of attending college (including tuition, room and board, books and supplies, and transportation) is $22,826 a year for public in-state college or $44,750 a year for private college, according to the College Board. If tuition costs continue to soar at 400%+ rates, there might be no way for our kids to get a college degree in the future without incurring a significant amount of debt.
I don’t mean to scare you. I’m terribly concerned myself. Let’s take a brutal look together at the World’s Simplest College Cost Calculator. Enter your kid’s age, adjust the assumptions, and hit the calculate button to get a result like the one below:
Depending on the age of your child and whether you choose the average public university or private university costs, you’ll need to save a few hundred to over a thousand dollars a month to cover college costs completely.
Here is the good news, though: Even saving a third of expected college costs can make a big dent. Instead of saving up for the entire four years of college, Money says:
a more realistic goal is to try to save up one-third of your kids’ expected college costs, suggests Mark Kantrowitz, author of
Filing the FAFSA
and senior vice president of the Edvisors Network. To do that for an infant born this year, you’d need to save about $150 a month for a public college, and $220 a month for a private college.
Wondering where the other two thirds comes from? The idea is to spread the rest of the cost of paying for college over a lifetime to make the hefty price tag more manageable. So while one third comes from past income (in the form of what you’ve saved), another one third comes from current income at the time tuition needs to be paid (along with grants and scholarships), and the last third from future income (in the form of loans that you or your child will pay back later).
This buys you more time to finance the education and still contribute to other goals like funding your retirement account.
Most financial experts will warn you not to sacrifice your retirement savings for your kids’ college savings—after all, your kids can get loans for their education but you won’t be able to get a loan for your retirement. But if helping your kid through college is important to you—and you can get a tax break from a college savings account—set aside at least some money towards that college fund. As with retirement savings, every little bit helps and starting as early as possible lets us leverage the power of compound interest. Every dollar saved ahead of time for college, Money says, saves at least $2 in debt payments after graduation.
Where to Save for College
Now that you know how much to set aside, where should you put it? You have several options.
529 Plans
529 plans are the most common types of college savings accounts, thanks to their tax advantages. Like Roth IRAs for retirement, 529 plans let earnings on your investments grow free of income tax when you withdraw funds for qualified higher education expenses.
Many states also offer tax credits for your contributions. These can be significant: a Morningstar survey found that the average extra savings from state tax benefits amounts to $87 for every $1,000 invested—or 8.7%. See if your state offers tax benefits with this chart before you choose a 529 plan; if you’re doesn’t offer many benefits, you might want to shop around since you can sign up with another state’s plan.
Besides self-directed 529 plans, there’s another type of 529 plan: prepaid tuition plans. As the name suggests, you pay ahead for tuition to lock in current rates. A dozen states offer their own prepaid plans, but most are open only to state residents. The Simple Dollar highlights these state plans, including the attractive Massachusetts U.Plan, which is open to everyone in the US and will give you your investment back plus interest should your child attend school in another state.
The Private College 529 Plan is a national prepaid plan covering over 270 private colleges and universities in eleven states. You purchase tuition certificates that are good for 30 years at participating schools (admission is not guaranteed, of course). Duke, Princeton, MIT, and Stanford are among the participating colleges in the Private College 529 plan.
What if your child doesn’t go to one of these colleges or to college at all? With all 529 plans, you can keep the money in the account and use it for another family member. Or if you take the money out for a reason other than to pay for higher education expenses, investment earnings will be subject to federal income tax plus an additional 10% tax penalty. For the prepaid 529 plans, you can withdraw the money for another non-participating school without penalty, but in most cases, you’ll only get your contributions back—not any interest growth.
Compare 529 plans over at Morningstar.
Coverdell Educational Savings Accounts
A Coverdell ESA is another tax-advantaged education savings account. They don’t offer the state tax credits that many 529 plans offer, but earnings are free from income tax if used for qualified withdrawals—and these include not only college but also K-12 and graduate school expenses. That gives you more flexibility. It could come in handy if your child is a junior in high school and it looks like she might get a scholarship—you can funnel more money towards high school expenses and/or save it for grad school. You can have a 529 and a Coverdell at the same time.
On the downside, Coverdells have several limits. You can only contribute $2,000 a year or else pay a 6% tax on any contribution above that. Because of that low contribution limit, you need to be particularly careful about any annual maintenance fees charged by the investment firm handling the account; those can significantly eat into your overall investment return.
Also, you can’t contribute to the account after the beneficiary turns 18 and he/she has to use the money before turning 30 (or else get hit with the 10% tax penalty and income tax). Finally, high-income earners making more than $110,000 (single filers) or $220,000 (joint filers) might not be able to take advantage of a Coverdell account.
Savings for college has a good comparison of Coverdell ESAs versus 529 Plans here.
Roth IRAs
Roth IRAs are typically considered solely for retirement, but parents can use them as college savings vehicles as well. Any contributions you make to the Roth can be withdrawn tax- and penalty-free if used for qualified educational expenses, such as tuition, books, and room and board. The main benefit of using a Roth to stash away college savings is the flexibility: If your child doesn’t go to college or gets a full scholarship, your money can be put towards your retirement instead of being tied up in a 529 plan, subject to a 10% penalty. You also have more investment options than with 529 plans.
There are downsides, though. Roth IRAs are limited to contributions of $5,500 a year and only available to joint filers making less than $176,000 a year. Also, if your child needs financial aid, after the first year of taking out money for college from a Roth IRA, that will count as income and could negatively affect next year’s financial aid.
Finally, because your child would likely start college sooner than you’ll enter retirement, the investments you choose in the Roth IRA should be more conservative. If you end up using that money not for college but for your retirement instead, that could affect your overall investment return. (But, hey, it’s still more money in your retirement fund!)
Other Types of Accounts
US Savings Bonds and UGMA/UTMA accounts are old-school methods of saving for college, but they don’t really make sense these days. Savings bonds’ interest rates are abyssmal and the UTMA and UGMA accounts (custodial accounts) only make sense if you’re sure your child won’t need financial aid.
How to Save for College and Other Financial Goals at the Same Time
Money suggests this strategy/order for divvying up your savings budget:
If you live in one of the states—or the District of Columbia—that offers a tax break:
Save in your 401(k) up to your employer match.
Pay off high-interest debt.
Build up six-month emergency reserve.
Save in a 529 college savings plan up to at least one-third of your expected college costs.
Put money in a Roth IRA (if you qualify), since this money can be used penalty free for college besides retirement
If your state doesn’t offer any tax benefit:
Save in your 401(k) up to your employer match.
Pay off high-interest debt.
Build up six-month emergency reserve.
Put money in a Roth IRA (if you qualify)
Save in a 529 college savings plan.
You’ll notice that the first three steps are the same for both scenarios. The main difference is whether or not you can get a state tax benefit for the 529 plan. If so, prioritize that; otherwise, choose the Roth over the 529. You might choose to add in a Coverdell for more flexibility, of course, and adjust the plan for your family’s needs.
Although it’s definitely still possible to succeed without a college degree, overall, studies suggest college is still a worthwhile investment. Good luck planning for it!
Photos by Bloomua (Shutterstock), leosapiens (Shutterstock).