If you have small children, it can be scary to think about how much college will cost by the time they graduate high school and head off on their own.
Household student loan debt has increased by 828 percent since 1999 and the average cost of college far outpaces the rate of inflation. The expenses are only expected to continue to rise for the foreseeable future.
So yes: it’s completely natural to feel uneasy about how your family will handle college education for your children. But that doesn’t mean you can’t do anything about it.
How Much Do You Need to Save (and Where Should You Save It)?
Start by getting an idea of how much you might need to save. A specific number can help you feel less overwhelmed since you can break down that total into a smaller, more manageable monthly savings target to hit.
The New York Times offers a number of simple rules of thumb to follow for how much you need to save for your kid’s college. Keep in mind these numbers can change based on your family’s preferences and goals.
Parents should also remember they’re under no obligation to pay every last cent of their child’s higher education expenses, either. Remember that kids can earn scholarships and grants (especially if you encourage and support them to do so throughout grade school) or pick up part time jobs to help with costs.
Your family can also work together to determine the best school that most closely aligns with your child’s career goals rather than simply choosing a university based on brand recognition (which can help you avoid the most expensive school in your state).
And while it may not be anyone’s first options, student loans aren’t always the worst option — especially if your child can take out a small amount they can reasonably expect to repay based on their salary expectations from their first job out of college.
Regardless of whether you want to pay your kids’ way through college or just help them out a little, now is the best time to begin saving. For many people, that process begins with a 529 college savings plan.
What to Think About Before Opening a 529 College Savings Plan
A 529 college savings plan is a popular choice for education savings because of the federal and state tax advantages.
Earnings in a 529 college savings plan grow tax-deferred. Distributions are free from federal taxes if you use them for qualifying education-related expenses on the beneficiary’s behalf.
Those qualifying expenses include costs like:
- Tuition and fees
- Books, supplies, and equipment
- Room and board
You can use the money you save in a 529 plan for non-qualified expenses, too. But that erases those tax advantages and leaves your earnings subject to federal income tax plus a 10 percent penalty.
That means money you put in a 529 plan should stay there until it’s time to use it for education expenses. (There are a few caveats to this — should your kids receive scholarships, for example, you can withdraw an amount equal to that scholarship without the penalty.
Some states offer even more tax incentives. For example, Utah gives state residents a 5 percent tax credit on contributions up to a certain amount, depending on your tax filing status.
You don’t need to be a resident of a state to use its sponsored plan, but you do need to be a resident to get the tax benefits. If your state’s plan doesn’t offer state tax benefits, look at other states’ plans to compare fees and fund selection.
529 Plans Aren’t Perfect
There’s no one-size-fits-all solution to college savings, and a 529 college savings plan may not work for everyone. Here are some reasons why:
You have limited investment options: Although you can shop around, many states don’t have a wide selection of funds. If you’re trying to maximize your earnings, this can be a huge roadblock.
Your child might not go to college: With the cost of college rising, there may be more alternatives by the time your kid comes of age. Unlike with the scholarship exemption, you can’t withdraw the cash penalty-free if your child chooses another path and won’t use that savings for a university.
You could change the beneficiary to another child in this case. But if you don’t have any other children or you have sufficient savings for your other kids, it could pose a problem.
Potentially high fees: Many state plans charge an extra layer of administration fees. Some states have brought down the fees to reasonable levels, but you may get better options if you look into other investment accounts.
For College Savings and Other Needs, There Might Be Better Options
If you’re not sure whether a 529 plan is right for you, or you want to split up your college savings, consider these options:
A 529 prepaid tuition plan: This option allows you to purchase credits at today’s tuition cost for your child to use for future tuition expenses.
If you buy a full year’s worth of credits, your child will get a full year’s worth of credits. It doesn’t matter how much tuition increases in the meantime. You’ll also get the same tax benefits as you would with the 529 college savings plan.
The main issue with the 529 prepaid tuition plan is that it’s based on the cost of in-state tuition. If you move or your child goes to school out of state, he or she may need to pay more. You must be a resident of the state in which you set up the plan, too.
Coverdell Education Savings Account (ESA): Similar to the 529 college savings plan, the Coverdell ESA differs in that you can use the funds for any educational expenses, including private K-12 school costs.
The main drawback is that the IRS limits contributions to $2,000 per year — and you’re not eligible to create one if your modified adjusted gross income is more than $110,000, or $220,000 if you file your taxes in a joint return.
Roth IRA: This is primarily a retirement account. However, Roth IRA rules allow you to withdraw money from the account tax- and penalty-free for certain qualified expenses.
Those rules include college costs, but you must take the distribution at least five years from the time you made your first contribution to the account. This is a good option for parents who want tax advantages (because Roth earnings grow tax-free) but don’t live in a state that offers tax benefits for contributing to a 529 plan.
It also solves the problem of what to do with the money if your kid doesn’t go to college. You can leave the funds invested for your own retirement or for another expense your children face later in life (like getting married or buying a home).
You won’t be able to withdraw your earnings for those purposes, but you can take out your contributions at any time. Keep in mind that like the Coverdell ESA, Roth IRAs are subject to income limits.
Taxable investment account: If you want a better fund selection and more control over your costs, you may want to consider a taxable investment account. Earnings will be taxed when you withdraw them, but you’ll have the freedom to include other savings goals, like a future wedding, a car, or a graduation gift.
You can even have separate investment accounts for each goal, which can help you keep track of your progress.
Do What Works For You
There’s no right answer to how you should save for your kid’s college education. You can put all your eggs in one basket with a 529, or you can spread them out to take advantage the benefits of different savings and investment accounts.
I have clients who opt to put their full force behind funding a 529 plan and I have others who opt to put 50% of their designated college savings into a 529 plan and 50% into a separate taxable investment account in order to diversify their options.
Take the time to research each option and don’t hesitate to reach out to a fee-only financial planner if you need help evaluating which provides the best solution for you.
Together, you can dig into the details of the tax incentives and fees to get a clear picture of which path you should take. The more you know, the more you’ll save.