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Many parents want to save for their child’s education, but they just don’t know where to start. In this guide, we’ll provide actionable advice on when you should start saving, what type of savings account you should use and how much you should save each month.
Each year, millions of students enroll in college for the first time. For many, the college journey began years ago when their families started planning and saving for college.
Many parents want to help their children go to college, get a good education and land good jobs with earning power. But they also have questions about when they should start saving, where they should stash the money and how much they should be saving each month.
A recent Sallie Mae survey showed that 98% of college students and parents believe college is an investment in the future. Unfortunately, less than half of families who knew their child would attend college had a plan to pay for that investment before enrollment time.
This guide to saving for college aims to help you make a plan to fund your child’s education.
Table of Contents
Before we get into the nuts and bolts of saving for college, let’s explore how much college costs. According to College Board, the average annual published in-state tuition, including fees for room and board, for a four-year public college or university is $20,770 for the 2017/2018 school year. If you opt for an out-of-state institution, the average jumps to $36,420 per year. A private nonprofit university will set you back $46,950 a year.
Those are today’s numbers, but the cost of a college education is going up. According to MassMutual’s college savings calculator, a family with a 5-year-old child starting kindergarten in 2018 can expect to pay a hefty amount for four years of school when their child enters college in 2031.
- Four-year in-state public college: $163,279
- Four-year out-of-state public college: $287,466
For many millennials just starting a family — and who may still be paying off their own student loans, buying a home and trying to save for retirement — those numbers are staggering. Maybe they’re even so overwhelming that you’re tempted to deal with the issue by putting it off, as so many of us do with other things in life.
But keep in mind that, with the help of scholarships and other forms of financial aid, you may not have to cover the entire cost yourself.
Mark Kantrowitz, publisher of PrivateStudentLoans.guru and the author of several books about paying for college, says you should aim to save about a third of future college costs.
“Like any major life-cycle expense,” Kantrowitz advises, “the cost (should) be spread out over time, with about a third coming from savings, a third from current income and a third from student loans.”
Even cut into thirds, those projections can seem daunting to some, but the longer you put off planning for college, the bigger a challenge it can become. It’d be a smart move to start thinking about it as soon as possible.
Simply put, the time to start saving is now. The younger your child is when you start saving, the better off you’ll be due to the power of compounding.
You may have heard about the power of compounding in regard to retirement savings. It’s the snowball effect that happens when you earn interest, dividends and capital gains not only on your original investment, but on the earnings themselves.
The U.S. Securities and Exchange Commission provides a handy compound interest calculator so you can see compound interest in action.
Imagine that when your child is born, you invest $5,000 in a college savings account that earns 8% annually. If you never invested another dollar, by the time your child reached age 18, you would have $19,980 to put toward your child’s education.
If you were able to contribute an extra $250 per month to your initial $5,000 investment, the results are even more dramatic. You’d have $132,331 by the time your child reaches age 18.
On the other hand, consider if you wait until your child is 15. With an initial investment of $5,000, earning the same 8% return and only three years to save, you would have to save about $3,235 per month to achieve that same $132,331 nest egg.
A recent study from MassMutual demonstrates just how much getting an early start matters. The study found that parents who started saving upon the birth of their child or before their child’s first birthday saved an average of about 40% more than those who started saving after their child turned 10.
Mike Fanning, head of MassMutual U.S. and a father of four millennials, says that, for families who have very young children and are struggling to set aside money for college, age 5 can be a good tipping point to start saving.
“That’s when many parents stop paying for full-time childcare expenses,” Fanning says. “By putting a percentage of the money freed up from childcare expenses toward saving for college, parents can save more without having to change their current spending habits.”
So now we know there’s no time like the present when it comes to saving for college, but where should you stash the cash?
Here are five primary vehicles for college savings.
529 College Savings Plans
A 529 College Savings Plan is a popular option for many parents today. Contributions to 529 plans may not be tax deductible. And, starting in 2018, if your contributions plus any other gifts, to a particular beneficiary total more than $15,000 in a year, you could trigger federal gift taxes (the threshold was $14,000 for 2017). Money in the account grows tax-free and distributions are exempt from federal and sometimes state taxes as long as the money is used for qualified higher-education expenses.
You can invest in any state’s 529 plan. However, Kantrowitz says that many states provide a state income tax deduction or credit for contributions to their respective state plan, so it’s a good idea to consider your own state’s plan and weigh the tax benefits against another state’s plan that may be offering lower fees, particularly if you have a state income tax obligation.
Assets in the plan are typically considered assets of the parent for financial aid calculation purposes, so they have less of an impact on the child’s financial aid eligibility. And beginning in 2018, as a result of the changes to the tax code, funds from 529 plans can be used for qualifying education expenses at private elementary and high schools.
Can I switch my 529 plan?
If you have a 529 plan but you realize that the fees are too high, the plan is underperforming, or you simply want to participate in another state’s plan for the state income tax benefits, you can roll the funds into another 529 plan. The IRS allows one tax-free rollover per beneficiary within a 12-month period.
However, when you roll the funds out of one state’s plan, that state may require you to pay state income taxes on any contributions for which you previously received a tax deduction.
529 Prepaid Tuition Plans
Subject to some of the same guidelines as its 529 counterpart, 529 Prepaid Tuition Plans also let families save in a tax-advantaged way, again with certain limitations on tax exemptions. But rather than simply saving money and hoping college tuition doesn’t significantly increase, a prepaid plan lets the account holder purchase future credits at a college or university at current prices.
The benefit of a prepaid plan is that they offer peace of mind. As long as you make contributions to the plan as calculated when you enrolled, your investment is guaranteed to cover the agreed-upon number of credits, no matter how fast tuition rates rise.
States are permitted to offer both types of plans: prepaid tuition plans and savings plans. However, a qualified education institution can only offer a prepaid tuition type 529 plan. However, tuition benefits are typically limited to the rates at your in-state public colleges and universities. If your child decides to attend an out-of-state institution or a private university, plans typically pay only the average of in-state public college tuition, and you or your child will need to cover the difference.
Coverdell Education Savings Accounts
Coverdell Education Savings Account, or ESA, plans can be used for elementary through college education, so many parents use them to save for tuition at private elementary and high schools as well as college.
Contributions must be made in cash and are not tax deductible, but distributions are not taxed as long as the money is used for qualified education expenses. You can contribute up to $2,000 per year per beneficiary if your modified gross income is under the limit set for the given tax year. Organizations, such as corporations and trusts, can also contribute regardless of their adjusted gross income.
UGMA/UTMA Custodial Accounts
Uniform Gift to Minors and Uniform Transfers to Minors accounts aren’t specifically used for education savings, but they are accounts, often investment accounts, that you can use for minors. The accounts are designed to pass control of the funds to the child once they reach age 18 or 21, at which point the child can spend the money however they like.
Note that assets in a custodial account are owned by the child and can affect their eligibility for financial aid, and earnings can impact their income tax.
Savings bonds were once a popular way to save for a child’s education, but their allure declined after the creation of 529 plans, with their accompanying tax advantages and wide variety of investment options.
Families can purchase U.S. savings bonds via the Treasury Direct website for as little as $25. While you’re typically required to pay tax on the interest earned, if you cash in the bonds under an education savings bond program, you may be able to exclude that interest from your taxable income.
Though risk is low with savings bonds, the rate of return is typically very low (currently just 0.10%). You may be able to generate a better rate of return using a 529 or custodial account.
Should I save for college with an IRA?
Saving for college in an IRA has some benefits. But is it a good idea? Funds in a traditional IRA are not counted in need-based financial aid calculations, but if you withdraw or distribute any deductible contributions and earnings from a traditional IRA, you’ll have to pay the income tax due since the contributions weren’t taxed before they went into the account, plus if you withdraw before you reach age 59½, you will potentially have to pay a 10% penalty tax unless you qualify for an exception.
Funds in a Roth IRA may be withdrawn if it’s a qualified distribution or withdrawal that’s limited to the contributions (leaving the earnings untouched), which allows the funds to be used without taxes or penalties so long as they’re used for qualified higher education expenses. If you are under age 59½, you may be assessed an additional 10% penalty tax if you don’t qualify for an exception.
Keep in mind though that the distributions count as income and may reduce the amount of need-based aid your child is eligible to receive the following year.
To learn more about early distributions, visit Publication 590-B by the IRS.
So which method of saving for college should you choose? Both Kantrowitz and Manning recommend a 529 College Savings Plan. These plans can offer more tax advantages and investment options than ESAs, custodial accounts or savings bonds.
A 529 College Savings Plan will also have higher contribution limits. IRS rules simply specify that your contributions “can not exceed the amount necessary to provide for the qualified education expenses of the beneficiary.” Keep in mind that some state plans set their own contribution limits.
And if you contribute more than the annual gift tax exclusion amount ($15,000 per contributing parent for 2018) to any individual plan, you may have to pay a federal gift tax.
What happens to money in a 529 College Savings Plan if it can’t be used for education?
It is possible to save too much for college. If you have unused funds in a 529 plan, you have several options.
- You can withdraw the money, but you may owe income tax and a 10% penalty on the earnings portion of your withdrawal.
- If your child received a scholarship, you can withdraw an amount equal to the scholarship without paying a penalty. Note that you’ll have to pay income taxes on the earnings portion.
- You can keep the money in the account and switch the beneficiary to an eligible family member, such as another child who will be needing college funds in the future.
Is there a magic number that you should be saving each month for your child’s education?
The amount you save will depend on a number of factors, including how old your child is when you start, what type of college or university your child plans (or will realistically be able to) attend, and what you can afford.
Run the numbers using MassMutual’s college savings calculator to consider how much you’ll need to save for your child’s college education. Then enter that figure into the Securities and Exchange Commission’s savings goal calculator to give yourself an idea of how much you should try to save every month to meet your goal.
If you run the numbers and your result just isn’t feasible, don’t let that stop you from saving at all. Do what you can now. You may be able to increase contributions in the future as your income grows.
You can also look at other ways to reduce costs, such as going to a less expensive school, having your child live at home instead of on campus or applying for scholarships.
Any parent understands the truth to the old adage “The days are long, but the years are short.” Before you know it, the child you’re currently teaching to look both ways before crossing the street will be off to college.
Each dollar you save today is one dollar (or more with the power of compounding!) that you won’t have to borrow or rely on someone else to provide tomorrow. So even if you’re getting a late start or are only able to save a small amount each month, you’re better off saving something than doing nothing.