As a new parent, I am sure you’re painfully aware of how expensive college is, and will be. You may wonder how in the world are you going to save that huge sum needed for your child’s college education. This article is design to help you walk through each step — e.g., getting your finances in order, determining how much you should save, and how to make the most of your college savings with a practical investment plan.
Photo by Beard Papa via Flickr
Don’t save for your child’s college education until you’re out of debt and have your retirement savings on track.
Before you can realistically think about saving for your son or daughter, there are two really important things you must take care of first: (1) get out of debt and (2) save for your retirement. If you don’t have these taken care of, stop right here and go read my Dave Ramsey’s Baby Steps article. Once you’re out of debt and have your retirement savings on track, it’s a matter of balancing college savings against other financial priorities.
Before you consult a college savings calculator, there are a few things to think about.
First, what do you feel is the right level of contribution for you as a parent versus your child? Here’s a great article by Kevin Geary that discuss parents versus child’s responsibility when in come to college savings. Each person will have a different answer for this. I personally think contributing enough to support 4-years public college is the least I could do, and letting my son pay for the rest if he wants more.
Second, what is the level of education you’re planning to support?
Now, try this college savings calculator by College Board and plug in your numbers. For example, 15 years from now a 4-year in-state public college will cost $164,209, using college cost inflation rate of 5%.
Consider the calculated college cost number your stretch goal and it’s not the end of the world if you can’t save that much.
Don’t panic when you see the number because this is just the starting point. Beside you don’t have to cover 100% of the expenses from your college savings account. You can pay from your then current income and by borrowing. Moreover, there are many ways to lower your child’s college education costs — i.e., advanced placement, scholarship, etc. Lastly, you should be saving for the expected family contribution (EFC) and not the full cost of college education.
In our example, let’s assume that we want to save about 50% of the total cost, or $82,000.
Here are more resources on spending less for college:
Depending on when you start, you could have 17 years or more to build up your child college fund — actually more if you’re proactive and start saving before your child is born. This gives you long enough time horizon for you to invest fairly aggressively for this goal — as opposed to just saving it in an online savings account with the highest rate.
For this discussion, your investment plan could be as simple as:
For example, here is a possible investment plan to save $82,000 in 15 years:
Now the question is exactly where should you be saving money earmarked for college. The good news is the government wants you to save college and offers some excellent tax-advantaged options. Two most popular ways to save for college are 529 college savings plans and Coverdell Education Savings Accounts (ESA).
There are other ways, such as, Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Generally, you will have to consider pros and cons before choosing the method, or a combination, that work best for you.
Personally, I think 529 Plan and ESA are the best. Here’s a high level comparison between the two. Please note that I am not discussion 529 Prepaid College Tuition Plan here.
|529 College Savings Plan||Coverdell ESA|
|Non-deductible and grow tax free, but contributions can be deducted for some states||Non-deductible and grow tax free|
|Withdrawals are tax free for qualified higher education expenses.||Broader definition of qualified expenses — i.e., savings can be used for elementary education, secondary education, tutoring, and education-related computer expenses.|
|Generally sponsored by individual states.||You can open an ESA account with almost any financial institution.|
|Assets are managed by independent investment firms or state government agencies from a limited selection of investment options. You can select the investment and asset allocation.||Assets are managed by you from a broad range of investment options. You can do almost everything that you can do with a normal investment account.|
|Anyone can open a 529 savings account regardless of income level.||Only individuals with modified adjusted gross income (MAGI) of less than $110,000 ($220,000 if filing a joint return) are eligible to contribute to a Coverdell account.|
|Annual contribution limit between $100,000 and $350,000 depending on state. You can contribute up to $13,000 ($26,000 for married couples) a year without gift-tax consequences.||Annual contribution limit of $2,000 a year.|
|No age restriction for the beneficiary. You can even contribute under your name then transfer to your child when he/she is born.||The beneficiary must be under 18 to receive contributions, must use assets before age 30.|
If this happens, you’ll find that 529 college savings plan is a lot more flexible than the Coverdell ESA. With a Coverdell account, the beneficiary must use the assets by age 30, or a new beneficiary must be named.
With a 529 savings plan, you can leave the money in the beneficiary name for as long as you want. You can also name new beneficiary who is a member of the current beneficiary’s family, including yourself, at any time.
If you withdraw the money for non-qualified expenses, you will pay ordinary federal income tax plus a 10% penalty on the earnings.
Please note that this is very general and there are many caveats to the actual rules.
Here are a few tips to consider when saving for college: