How to Save for College
It probably comes as no surprise that college has become really expensive, and the costs continue to rise year after year. So if you’re planning on helping someone pay for higher education – your child, grandchild, niece, nephew, or neighbor – then it’s important to start planning early. Here’s what you can do.
Here’s what we cover in this guide
When to start saving
How much to save
Where to save
529 Plans
ESA Plans
Alternative ways to save
When to start saving
The answer is probably obvious, but basically you’ll want to start saving as soon as possible. For most of us, saving up for our kids’ college is a years long process. So the sooner you start, the less you’ll have to save each year. And you’ll also benefit from your savings compounding over time. Time is a major asset here – use it your advantage.
So if you have children, or are even just planning on having children in the near future, it’s probably a good idea to start saving. Even if it means starting small and building up over time. The key is to start the process and then build momentum towards your goal with regular contributions.
How much should I save?
As you probably know, higher education is expensive – like, scary expensive.
According to The College Board’s annual Trends in College Pricing report for the 2022-2023 school year, the average annual cost to attend college (tuition, fees, room and board) was $23,250 for four-year public universities and $53,430 for four-year private institutions. And unfortunately, these costs tend to rise over time.
So figuring out the exact amount to save can be somewhat challenging. But a commonly recommended rule of thumb is to try to save at least one third of the total expected cost.
The idea is that one third will be covered by savings, one third will be covered by your current income, and one third will be covered by scholarships, financial aid, and student loans. Of course this won’t be right for everyone, and you’ll need to figure out a strategy that works for you and your family. Obviously if you want to be able to cover the full cost yourself, you’ll need to save more.
Where to save your money
There are a number of places you can keep your child’s college fund, starting with a savings account at the most basic level. Your money will be secure, and you may even earn some interest. The downside with a savings account though – you probably won’t earn that much interest. Also, some of the other options offer compelling tax benefits, making them potentially more attractive choices.
These include 529 plans and ESA plans. Let’s take a look at each.
529 Plans
A 529 is a tax-advantaged savings plan designed specifically for education savings. The name comes from the fact that they’re authorized by Section 529 of the Internal Revenue Code.
The was a 529 works is similar to how a Roth IRA works, in that you contribute after-tax money, and then that money can grow tax-free, meaning you won’t have to pay any investment taxes on dividends, gains, or interest. And you also won’t have to pay any taxes when you take it out, as long as you spend it on qualified education expenses. This would include tuition, fees, textbooks, and in some cases room and board. Originally this only applied to college expenses, but now you can even spend 10k a year on qualified expenses for K-12.
Technically, 529’s are state-sponsored plans, but you don’t actually have to be a resident to sign up for a particular state’s plan. However, there may be some benefits to doing so, like having your contributions deducted from your state taxes.
Pros of a 529 plan
• Tax advantage – Once you’ve contributed after-tax money, your money grows tax-free, and you wont owe any taxes when you take it out if you spend it on qualified education expenses.
• Anyone can contribute – Parents can set up a plan for children and grandparents can do the same. You can even set one up for yourself. You’re also not limited based on income the way you are for a Roth IRA or an ESA which we’ll cover next.
• High cap for maximum contributions – There is a total cap you can have in the fund, which varies by state. But generally these amounts are fairly large, typically ranging from about $300,000 to $500,000.
Cons of a 529 plan
• The money must be used for education expenses. Otherwise you’ll have to pay income taxes and a 10% penalty on the money your fund earned. However, you can change the beneficiary of the fund to someone else if the intended recipient doesn’t need the money.
• The money held in a 529 might impact how much financial aid you receive. This is a little complicated and can depend on the school as well as who owns the account (the student, parent, or grandparent). But it might mean you’ll receive less aid than you would get otherwise.
• Your investment options might be limited and you may face higher fees than you would in a brokerage account or IRA. You’ll want to do a little digging before you sign up with a particular state plan and know what your investment options will be with that plan.
ESA Plans (Education Savings Account)
Like a 529, an ESA (often referred to as a Coverdell ESA) is a type of tax-advantaged account specifically designed for education savings.
Pros of an ESA
• Similar to a 529, it offers a tax-advantage. Again, you contribute after-tax money, but that money is then allowed to grow tax-free (you don’t pay any investment taxes on dividends, gains, or interest). And when you take it out, it won’t be taxed, as long as it’s used for qualifying education expenses.
• Wider range of investment choices. You’ll generally have more investments to choose from than you will with a 529, where your choices will be limited to what’s offered by the plan. With an ESA, you can buy individual stocks, bonds, and funds of your choosing.
Cons of an ESA
• If your annual income exceeds a certain amount, you can not contribute to an ESA. As of 2022, a married couple reporting $190,000 of income or less can contribute the maximum amount, but contributions phase out at $220,000. (For single filers, the numbers are half these amounts, aka $95,000 – $110,000.
• Your annual contributions are capped at maximum of $2,000 per year per beneficiary. With 529 plans you have more flexibility with your contributions.
Alternative ways to save
While 529s and ESAs can be great ways to save for higher education, they aren’t your only option. So you’ll want to consider a few others.
Roth IRA – The Roth IRA is generally intended for retirement savings. But it can be used for education savings too. That’s because early withdrawals generally won’t be hit with the usual 10% penalty if they’re used for qualified education expenses. We should note though, if you do take money out early (before you turn 59 and a half) you will owe income taxes on any money earned in the account. But since your contributions were made after-tax, you won’t owe taxes on them (just on the investment earnings).
Taxable investment accounts – More general investment accounts like a brokerage account, can be another good option. While they don’t offer a tax-advantage, they do offer flexibility. You can choose from a wide range of investment options, and since there’s no tax-advantage, there’s no penalty for spending the money on something other than education.
Summary
We obviously don’t know for certain what the future holds for any of us. So we all need to be prepared for a range of future financial scenarios. And if sending your kids to college may be in the cards, it’s a good idea to start planning for those tuition bills sooner rather than later. The are a number of ways to do it, but the key is to be proactive and get started early.
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