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Saving for College Education With 529 Plan and Coverdell ESA

Saving for College Education With 529 Plan and Coverdell ESA

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For parents who are saving for their child’s college education, the main concern is not being able to save enough. The first step is to decide if you’re in the position to help your child. This may sound harsh, but your finances take precedence over your child’s college savings. Goals like paying down your debt, saving for retirement, and maybe even saving for a home purchase come first. Remember that your child has many options while you do not.

Get Your Finances In Order

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 really 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
  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.

How Much Will College Cost in 18 Years (or less…)

The first step is to figure out how much college will cost in the first place. After that, it is a matter of how much you’re expected to contribute to your child’s education, and finally, how you’re going to go about saving that much money.

Most kids go to college when they turn 18 — so 18 years is when most parents think about this. If you have less than 18 years to go, that’s fine too. You can change the number of years in the calculation.

According to this College Cost Projector at Vanguard.

  • 4 years of in-state Public school costs $85,480 today and about $221,667 in 18 years
  • 4 years of out-of-state Public school costs $149,720 today and about $366,256 in 18 years
  • 4 years of average priced Private school costs $194,040 today and about $503,185 in 18 years
  • 4 years of expensive Private school costs $240,820 today and about $624,497 in 18 years

Vanguard College Cost Projector

Yikes!

To check my number, I found another calculator from FinAid. This site also offers some additional useful information that I summarized here:

  • College costs increase about twice the inflation rate; currently, increases have averaged 5% to 8%.
  • Total cost includes tuition, fees, room and board, books, travel, and incidental expenses.
  • According to the College Board’s Trend in College Pricing, the 2018-2019 average annual total costs were:
    • $12,320 for two-year public colleges
    • $21,370 for four-year public colleges and universities (in-state)
    • $37,430 for four-year public colleges and universities (out-of-state)
    • $48,510 for four-year private colleges and universities

The numbers are the same as the one offered by Vanguard above.

How to Pay LESS for College

Unless you’re independently wealthy, I believe that the entire process for choosing which college to go to and how to fund the education should be a business decision. Teach your child early on about the consequences of their choices and why choosing to go to a prestigious Ivy League school may not be the best life decision.

1. Choosing the Major

This is not something that you can decide in a vacuum without your child’s input; however, it should be part of your planning process. For now, let’s assume that your child will choose a marketable major that a good chance of paying for itself. Hopefully, your child doesn’t fall in love with a major that has limited career choices.

Keep this in mind, because it is something that you will nudge your child in the right direction as he or she grows up.

2. Choosing the School

The main criteria for selecting the right school should be which schools give you the best education and college-life experience in the desired field at the lowest cost. It should not be about location, brand name, sports teams (unless your child is getting a sports scholarship), and other less important factors.

In general, In-State Public and Community Colleges are the least expensive, and Out-of-State Private Colleges are the most costly. When your child is ready to go to college, you have to work together to figure out the Quality vs. Price that is acceptable to both.

Here is a power tip. You could also plan to have your child attend a less expensive school during the Freshmen and Sophmore Years, then transfer to a more prestigious school for the last two years. This will save a significant amount of money and allow your child to get that Ivy League degree.

3. Funding Sources

The good news is you do not have to pay for everything. There are funding sources available that could help you pay for college. Here are a few traditional funding sources:

  • Government grants and scholarships
  • School grants and scholarships
  • Work-Study Jobs
  • Student loans

Less common funding sources:

  • GI Bill – The GI Bill provides educational assistance to service members, veterans, and their dependents.
  • ROTC Scholarships – The ROTC programs financially assist college students in exchange for military service after graduation. The scholarship program is different for each branch of the military as follow:
  • Tuition Reimbursement Program – Many companies offer a tuition reimbursement program as part of the benefits package. If you can find the right company that will help you with your tuition, this could be an option to fund your college education while working.

Non-traditional funding sources:

  • Side hustles. Nothing should stop you or your child from trying to make money on the side.
  • Income-Share Agreements (ISA). Some investors are willing to pay for your child’s college education. In return, they are asking for a share of their future income. Here is an article about ISA at Business Insider.

As you can see, you don’t have to pay for all of the estimated costs above.

4. Paying Less for College

In addition to going to a less expensive school, there are additional options to help you spend less money for college:

  • Advanced Placement (AP) Courses and Exams – Your child can take some AP courses while in high school to satisfy some basic course requirements. If your child is capable and the high school offers AP courses, you could potentially shave off a semester or even two. AP courses are generally free, so you’ll be saving about half or a year’s worth of college expenses.
  • College Level Examination Program (CLEP) – Another way to get college credits at a fraction of the cost is to take CLEP Exams. The exams can help your child meet a lot of the basic and mandatory requirements (here is a list of the CLEP exams available from College Board).

These two options allow your child to save considerably on college expenses.

Another option is to take more credits per semester. When you’re a full-time college student, you’re charged a flat rate by the semester (vs. part-time students that pay per credit). The minimum credit requirement is typically 12 credits per semester, and you need 120 credits to graduate. This means most students average 15 credits per semester. However,

  • if you take 17-18 credits per semester, you can graduate one semester early.
  • if you take 20 credits per semester, you could potentially graduate one full year early.

The difficult part is scheduling the courses and be able to meet all the course prerequisites. Depending on your college’s course schedule, this may or may not be possible.

Child vs. Parents Contribution

Now that you know roughly how much college will cost and the various ways in which you can spend less for college education, it is time to figure out how are you splitting the costs.

Are you planning to pay for all of the shortfalls for 4 years of college? This is not the only option. Depending on what you’ve prepared for your child vs. what your child decided to do in the future, you could split the difference in a variety of ways.

I’ve put together a separate article that helps you address this question: Pay For College or Make Them Work for It?

Personally, I like the idea of saving just enough for a good 4-year public college education and have our son share the responsibility if he wants more. Here are four reasons why I want my son to pay for part of his college expenses:

  1. It is less burdensome on our lifestyle and effort to save for retirement. Also, we have to consider that we will most likely have to support our aging parents. We cannot let his college savings take priority over other more pressing goals. After all, he has student loans, scholarships, financial aids, and other options at his disposal. For example, he can choose to go to a less expensive school. We do not have the same kind of flexibility with elderly care and retirement expenses.
  2. It teaches him a life lesson about trade-offs. Specifically, he cannot have everything he wants, and if he really wants something, he will have to work for it. After all, 4-year Ivy League education is not a NEED; it is a WANT.
  3. It teaches him the value of money. We can show him the difference between a more expensive and less expensive school. Which one should he choose — go to a more expensive school and graduate with debt, or go to a less expensive one and possibly graduate with a positive net worth?
  4. Having our son share the responsibility of paying for his education may make him appreciate education more.

How about you? How much are you planning to save for your children’s education?

Saving Plans for College Education

At this point, you should have a reasonably good idea of what you need to save for college. Again, it is crucial to prioritize your goals and remember that college savings come afters paying down your debt, retirement savings, and maybe even buying a house.

Now the question is where should you be saving money earmarked for college. The good news is the government wants you to save for college and offers some excellent tax-advantaged options. The 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 the pros and cons before choosing the method, or a combination, that works best for you.

Personally, I think the 529 Plan and ESA are the best. Here’s a high-level comparison between the two. Please note that I am not discussing the 529 Prepaid College Tuition Plan here.

529 College Savings Plans Coverdell ESAs
Non-deductible and grow tax-free. Some states offer tax-deduction state residents. Non-deductible and grow tax-free
Withdrawals are tax-free for qualified higher education expenses. Has a 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 a plan with any state or with multiple 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. There is also an income limit of $95,000 to $110,000 for a single filer or $190,000 to $220,000 for a married couple filing jointly.
Very high contribution limits. 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. You can name a new family member as the beneficiary at any time. The beneficiary must be under 18 to receive contributions, must use assets before age 30.

More Information About 529 Plan

A 529 Plan is probably your best option. There are two main types of 529 Plans: Prepaid Tuition Plans and College Savings Plans.

  • Prepaid Tuition Plans let you purchase college credits at today’s price at a participating college.
  • College Savings Plans let you invest money that can be used toward qualified education expenses.

In my opinion, the College Savings Plan is far superior to the Prepaid Tuition Plan. The second thing to realize is that each State has its own 529 Plan. You can choose to open a 529 Plan with any state, or even with multiple states. The key things to consider are:

  • Some plans offer tax benefits for its residents. For example, Virginia taxpayers may deduct up to $4,000 per account per year from their Virginia state individual income taxes.
  • But the more significant factor is the investment options and expenses. There is a big difference between the worst and the best 529 Plans. If your state’s plan belongs to the bottom quarter of 529 Plans, you might be better off giving up the tax benefits and choose one of the top plans.

Example Investment Plan 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 a long enough time horizon for you to invest fairly aggressively for this goal — as opposed to just saving it in a savings account.

For this discussion, your investment plan could be as simple as:

  • Contribute $x per month. You could increase the contribution by 3% each year.
  • Start with 100% in equities and shift 5% per year to fixed-income investments.
  • Rebalance your portfolio once per year.
  • Shift to 100% fixed-income when your child is ready to enter college. This will help you preserve your investment and prevent any untimely loss due to the stock market downturn.

For example, here is a possible investment plan to save $250,000 in 17 years:

  • Contribute $600 per month in the first year, and increase the contribution by 3% each subsequent year.
  • Start with 100% in equities and shift 5% per year to fixed-income investments. We are using a 9% return for Equities and a 2.5% return for Fixed-Income in this example. Notice the expected return on investment that declines over the year due to a greater portion invested in fixed-income. 
  • Rebalance your portfolio once per year.
  • Shift to 100% fixed income when your child is ready to enter college.

Saving for College Education With 529 Plan and Coverdell ESA 1

What If Your Child Does Not Go to College?

If this happens, you’ll find that the 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 a 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.

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plonkee
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plonkee

Ideally I would save enough to cover the EFC for 4 years and a bit more. Super ideally, they’d get a scholarship and we could split the money 50/50.

KMC
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KMC

My wife and I have the exact same strategy as your commenter.

We took a guess at what in-state tuition would be based on today’s rate and the current (8-10%) year-over-year increase and came up with a number. If our kids want to go to a school more expensive then that, they’re welcome to but I won’t be paying the difference – they will.

Steve
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This is one of the best ideas I’ve read in a long time. Guaranteeing your child a college education at a public university but telling them they are on their own for a private university education is exactly the right mix of responsibility by the parents and the child.

I have pretty strong opinions about this, because I’ve never planned to pay for my son’s education, other than whatever grandparents, etc. contribute. I paid for my own education and frankly I expect my son to pay for his own, too – but this is a good compromise.

Chief Family Officer
Guest

I completely agree with you that college savings is not as big a priority as other areas – we are sacrificing college savings for retirement savings and in a couple of years, paying for private school (our local public school is terrible; I have plans to blog about this soon). We will definitely help our kids pay for college; but how much assistance they get depends on how much we can afford then, not just what they want. What I hope was implied in my previous comment is that simply that if you plan to save the full amount of… Read more »

KMC
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KMC

@Pinyo – We’re right in line with each other if you consider inflation. The College Board reports inflation-adjusted public college increases of about 4% for the last 20 years. I figure, if anything, states are going to reduce funding for higher ed.

This is one saving area one want to nail as close as possible. Here, it is possible to ‘save too much.’ With that in mind, we’re prepared to adjust a little bit either way if we’re not on track many years from now.

SavingDiva
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SavingDiva

I don’t have children yet. However, I would like to pay for my future child’s college tuition. My parents allowed me to graduate from undergrad with no loans or debts. I wish to do the same thing for my children. If I save too much (or they earn a scholarship), I would just give them the investment account to kick start their retirement fund….

Becca
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Becca

I grew up in a family that put a tremendous premium on education and so my parents saved pretty much all they could — more than the federal government expected of them, anyway. I think that was really important. If you don’t contribute what the feds think you should, then understand that your child either has a choice of delaying education until they are financially independent (usually legally defined as around age 25 — which cuts into *their* lifetime income significantly) or taking on high-interest private loans. To be honest, a lot of parents think that it is their money… Read more »

Jonathan
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Jonathan

I totally agree with your perspective on this one, it encourages ownership and the recognitiion of the value of money

Saving for College Education With 529 Plan and Coverdell ESA

by Pinyo Bhulipongsanon time to read: 10 min
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