Saving for College
Like many parents, you want to make your child's life a bit easier and give them a leg up (or maybe several legs). This might mean funding part of their college experience or maybe you are looking to supercharge your own college savings. This is no small task, but it doesn’t
need to be overly complicated or scary either. There’s no better time than now to start saving. Here are some things to think about when saving for college.
Key points
Start saving as early as possible to allow for maximum growth. Let time be your friend.
529 plans allow you to grow your money tax free when used for qualified educational expenses.
If the 529 money is not used for qualified expenses you will pay a 10% penalty in addition to taxes on the growth of the plan.
Using a savings account is fine if your timeframe to college start time is short (maybe 2 years or less).
Typical brokerage accounts are also acceptable and give you a bit more flexibility when it comes to withdrawing the money without penalties (they are not tax advantaged like the 529)
If you and/ or your child will be earning income during college, don’t forget to factor this into your calculations for costs. You don’t necessarily need to save for every last item, if your extra income will help cover some gaps.
Obviously, for the sake of this article, we’ll assume you or your child are planning to attend college at some point. We’ll get into 529 plans more below, but It’s worth mentioning now that trade and vocational schools are qualified expenses. Public, private and religious elementary or secondary schools can also qualify. This article will focus on college saving, but the concepts can be applied to various educational goals.
How much are you willing or able to fund?
This will be based on your personal preferences of what works for you, fits your budget and how much time you have to save. Do you want to fund all costs or would you like your child to pay for part? Is the potential college start date in 1 year or 15 years? Obviously trying to save $40k in a year would be difficult for most people, so we need to be realistic.
On the other hand, you have various other financial goals, like retirement or maybe you want to buy a house soon. Saving for your child's college is important, but it should not take priority over your own retirement. In either case, you’ll need to determine what that balance is between your various financial goals and saving for college.
For reference you can take a look at average college costs around the nation. This will help you get a better understanding of the amounts and types of costs you’ll need to consider. The average cost for public 4 year school (in-state) costs about $25k with tuition, room and board etc., while private schools are upwards of $50k. College isn’t cheap, hence the importance of starting to save early.
Before we keep digging, let’s do a quick example to illustrate how a little can go a long way when you use the power of investing and time.
We’ll assume your child will start college in 10 years.
You plan to fund the equivalent of about $10k per year ($40k total for 4 years) which would just about cover the average cost of in state tuition. The other costs like room and board we’ll assume are covered by your child’s part time college job and your extra income and savings at the time.
Your investments earn a reasonable average return of 5% per year. Early on in the saving process there is time to be a bit more aggressive with your investment choices (more stocks, less bonds) and as the college start date approaches you will want to be more conservative with your investment (more bonds and cash, less stocks). This assumes a higher rate of return early on and lower returns closer to the time you expect to withdraw the funds for school expenses.
Given the assumptions above, you should expect to invest about $250 monthly to get to $40k in ten years. Not bad. For reference, if you started when your child was born and assumed 18 years of saving you would only need to save about $110 per month. The key takeaway here is the earlier the better, but better late than never. In this example $250 monthly means you saved $30k over ten years and earned an extra $10k in investment returns. That is basically one year worth of tuition just for investing early! The $110 over 18 years equates to $23k of your savings and $17k of investment growth.
What is a 529 plan and why should you use it?
Think of a 529 as a savings plan that has major tax advantages when used for qualified education expenses. Imagine you invest $5k and it grows to $10k. Now imagine not paying taxes on that. Sounds great right? That's what a 529 plan can do for you. What are the qualified expenses? Basically expenses related to tuition, room and board, food/ meal plans, books and supplies etc. Obviously the government doesn’t want to give you tax free money unless you use it for what the plan is meant for.
There are 2 main types of 529 plans, savings plans and prepaid tuition plans. Savings plans are the most common and straightforward, basically the money you contribute is invested and likely will grow over time. Prepaid tuition plans are only available in certain starters and the specifics vary, but in general they allow you to lock in current tuition rates with a guarantee to grow at the same rate as college tuition. Room and board is not included in the prepaid tuition 529 plan. Both types are tax advantaged.
529 plans are run by each state, but you are not restricted to participating in only your state's 529 plan. Here is a list of some 529 plans you may be interested in. If you have a brokerage account, it’s worth looking to see what 529s are available directly. No sense in creating another investment account if you don’t have to.
Other saving methods
529 plans can be a great way to grow your college savings (tax free), but they are not the only way. Two other potential methods would be a savings account and a typical brokerage account. These will give you a little more flexibility and you won’t need to worry about paying penalties if you use the money for something else. The trade off for flexibility means you will pay normal taxes on any gains you realize.
Now you have a 529 or other investment account. What should you invest in?
Some 529s offer target date funds that will do most of the heavy lifting for you. These target date funds will automatically adjust the holdings as start date approaches, moving from riskier assets to more conservative assets. If you have this option, this is a great choice if you prefer to be as hands off as possible. Set it and (mostly) forget it.
If you prefer to have a little more input and plan to manage the types of investments, you can consider a general investing rules of thumb.
With longer time frames (say 5-10 years or more) you can be more aggressive (more stocks, less bonds) with your investments since you have more time to absorb market volatility.
As you approach the date when you plan to use the funds, you will want to progressively move more and more into conservative investments.
Be sure to align your investments with your goals and risk tolerance. College savings is probably not the place to make overly risky investments.
Click here to see our article investing basics.
Click here to see our collection of various portfolio structures that may be helpful.
Final Thoughts
Whether you are considering a 4 year university, or perhaps a trade school, starting your savings early will allow you to take advantage of the growth that can come from investing. So are 529 plans worth it? In my opinion, yes, tax free money is hard to pass up, but don’t forget that there are multiple ways to tackle this. A standard savings account is fine if your timeframe is short and a standard brokerage account can also work well and give you extra flexibility. In a perfect world you may use all three types. Remember if you or your child will have extra income during school, this can help fill in any gaps and reduce your saving burden, keep this in mind when budgeting.
Lastly, save early, save consistently and let time work on your side.