Saving for college: it’s a tremendously daunting topic that has many parents and students worried about their long-term financial outlook—and with the cost of college only continuing to skyrocket, these concerns aren’t exactly unwarranted. Cumulative student loan debt in the US has surpassed $1.4 trillion, which exceeds both consumer credit card debt and Apple’s recent record-setting market cap—YIKES!
The good news is there are many different ways to save for college, and there’s no right or wrong way to do it! Here are some questions you should ask yourself before diving in:
1. Have you taken care of personal financial goals?
For example, setting up an emergency fund, debt elimination (including credit cards and personal student loans) and retirement savings
2. Do you currently have kids?
If so, how much time do you have before they reach their college dreams?
3. How much should I save a month?
The general rule of thumb says you should be saving about 10% of your income towards your own retirement.
After taking care of your personal financial goals, you can start to consider saving for college. There are many options when looking to save for college, including Education Savings Accounts (ESAs), 529 Plans, Scholarships, UGMA/UTMA, and many other unconventional ways to accomplish college savings goals. I’ve heard many different ideas about how much or when a person should start saving for college, but every person’s savings strategy is tailored to their situation. This is my strategy.
Everything I know about saving for college I learned from my parents. I’m one of the lucky ones—I graduated from a 4-year college with ZERO student loan debt! I worked through college to keep myself afloat, but my parents were able to save enough to pay for my tuition, books, and housing. Their rules were simple—start early and contribute often. “A good rule of thumb,” says The Fortunate Investor, “is to contribute at least the age of the child as the % to of income to put in. If you can afford more, target 10% per year starting from the year of birth.”
My dad saved using the former principle. So when I was a year old, he was saving 1% of his income. When I was 12, he was saving 12%. If you can afford to put in more, that’s great! I’m not here to preach on any savings sweet spot for college, but this method strategically covers some sound investment principles.
“The earlier you put in the money, the more time it has to work and accrue interest.”
-The Fortunate Investor
Savings and investments are all about the power of compound interest. The Fortunate Investor advises that “the earlier you put in the money, the more time it has to work and accrue interest.” If you can, start saving when or before your child is born.
Here’s an example: saving $100/month with a modest 6% rate of return for 18 years would result in almost $40,000 of savings. But even if you save $500/month for 5 years at the same 6% interest rate, you’d only net $35,000 in savings. That’s $5,000 less, even though you put in 8,000 extra dollars total!
Mitigating Risk at Withdrawal
By investing small amounts early and increasing them as I got closer to college, my parents were able to mitigate their investment risk. The reasons for this are two-fold. First, they increased their contribution to the 529 as I got older and it became more certain that I would, in fact, go to college. Secondly, investing in a 529 plan is still an investment—and it’s difficult to tell where the market will be in the distant future. By increasing contributions gradually, my parents were risking less money when it was impossible to tell what the market would be like in 18 years, then increasing their contribution as their insight into the market became more reliable.
What is a 529 Plan?
A 529 Plan is generally a state-sponsored plan that allows you to contribute after-tax earnings to an account. These earnings grow tax-deferred. When you withdraw money to pay for educational expenses, the plan grants federal tax-exemption. The definition of “educational expenses” has recently been expanded to include computers and up to $10,000 annually for K-12 tuition. While these plans are generally state-sponsored, you’re not limited to plans offered by your home state. A person living in Nevada could usually purchase a 529 plan sponsored by Delaware and then go to school in Ohio.
Types of 529 Plans
Education Savings Plans
This is the most popular type of plan. It lets the saver open an investment account, where growth and withdrawals are not taxed if used for the beneficiary’s qualified higher education expenses. It includes tuition, room & board, and mandatory fees.
Prepaid Tuition Plans
This plan lets the saver purchase units or credits at a participating college or university (usually public and in-state) for future tuition at current prices for the beneficiary. Typically, these credits cannot be used for room & board.
Benefits and Drawbacks
State tax benefits
Many states offer tax breaks for contributions to 529 plans. Be sure to research the many types of plans, and especially the ones in your home state.
The saver can choose between many investment portfolio options, including mutual funds & ETFs. You should consider the purpose of this money and stay semi-risk averse when considering how to invest these funds. You might consider seeking the advice of a financial professional before making your decision.
Your money, not theirs
In most cases with 529 plans, the parent is the account holder and the child is the beneficiary. One unique feature of the 529 plan is that the account holder (donor) stays in control of the account. There are a few exceptions, but generally, the beneficiary has no legal rights to the funds, which allows peace of mind that the money will be used for its intended purpose, unlike UGMA/UTMA.
These plans are very low maintenance due to the simplicity of the tax implications. I’d consider a 529 plan a “set it and forget it” type of plan.
Unlike other educational savings plans, 529 plans don’t have eligibility requirements, although there are some lifetime contribution limits that vary by plan.
Only for educational expenses
If the funds are not used for educational expenses, any growth is taxed as capital gains. Other penalties may apply depending on your plan type. Be sure to speak with a tax professional before withdrawing your funds and keep track of your educational expenses.
Beware hidden fees
Some plans require maintenance fees or account setup fees. Again, be sure to do your research.
Depends on the child
Your child may not decide to go to college. In this case, you can transfer the beneficiary status to another family member or withdraw the funds and pay the penalties/taxes
There’s A LOT to consider, I know! As I said earlier, everything I know about saving for college I learned from my parents. Since then, I’ve been able to put their teachings into action in my own life. When my wife mentioned that she may want to go back to school for her master’s degree, I remembered my parent’s rules—start early and contribute often. I decided to open a 529 plan and contribute $50 per pay period. In the event my wife did go back to school, we would have some tax-advantaged relief to help pay for it. She ultimately decided that going back to school was not in the cards for her. Well, we don’t have any kids, but we do plan on having kids in the future. Fortunately, I can continue to contribute to my existing 529 plan until we have a child—then I can transfer the beneficiary status to them. And that gives us great peace of mind.
Everything I’ve mentioned above worked well for me, but everyone’s situation is different. Finding your perfect college savings strategy means researching all types of educational savings plans and leaning on the advice of your financial advisor or tax professional when making a decision to save through any of these different types of vehicles.
As always, feel free to leave comments as well as your own learnings and insights into the world of college savings!