Back to School Time: Best Ways to Save for College

*Brrrrrriiing* That’s the sound thousands of class bells are making across the country right now to signify the start of another school year. For many students, it will be their final year before going off to college. And for them and their parents, the concerns around how to pay for higher education are about to become even more real. With the right plan, though, saving for college can be less burdensome than they, or you, might think.

How much will you need?

To determine the cost of college in the future, let’s start by looking at college costs today. And because USC vs. UCLA is always such a hot topic around the office (particularly during football season), I will use numbers from their websites as proxies for public and private school costs.

Over the last few years, college prices have risen roughly 3% year over year1, so for this example, we will use that number when applying annual increases to the college expenses above. That means for 4 years of college starting in 18 years, you will need:

It’s no surprise that anyone might feel a little overwhelmed, but by starting early, you can use the power of compound interest to make sure you have enough saved up by the time college begins. If the ship has already sailed and you weren’t able to start saving early, don’t worry. You still have options to pay for college, which I will cover in a later post.

How much should you be saving today?

Now that we have an estimate for how much we will need by the time college begins, we can work backwards to figure out how much you should either be saving every year or putting aside as a lump sum today. I chose to use these two options for simplicity’s sake, but realistically, families don’t typically save in such a cut and dry manner.

The calculation for the lump sum option is a little bit easier, so I will start there. With this option, you are able to discount the college costs by an annual rate of return over the given length of time between today and when college starts. That means we have 18 years for that money to grow at a 5% average annual rate of return. Using these numbers, you will only need $100,762 today to reach a goal of paying for public school entirely, and $198,912 to pay for private school.

When you set aside money for college every year rather than all at once, the calculation is a bit different because not all the money is available to invest (and begin compounding) immediately. Because of that, you will need to stock away $8,620 per year for public school ($155,156 total over 18 years) or $17,016 for private ($306,292 total).

If you are lucky enough to have the lump sum amount available to allocate toward college savings for a child when he or she is born, then we can see that option will require less of a total cash investment. However, for many people that simply is not feasible, and making regular savings a goal is the best option.

What types of accounts should you use?

While you can certainly start saving for college in a regular old savings or brokerage account, there are a few other types of savings vehicles that can provide tax advantages (both federal and state) as an incentive to get parents to start saving early for their children’s education. Naturally, the tax rules around receiving the advantages are complicated and can depend on your state. Because of that, I will give you an overview of the general advantages and disadvantages of the most popular types of savings vehicles and won’t try to cover all of the tax laws here.

529 Plan

The most popular tax advantaged college savings vehicle (and the one we most often recommend) is the 529 Plan. It has been around in some form since 1996 and has gotten to be most people’s top choice primarily due to the potential tax benefits one can receive when using funds from this type of account to pay for college.

In a nutshell, the major advantage is that all capital gains, dividends, and interest can be earned tax deferred while the money sits in the account, and if the funds are used for qualified higher education expenses [link to IRS website], those earnings actually become entirely tax free. Going back to our examples above, that means 18 years of investment growth that doesn’t ever get taxed. Sounds like a great deal to me!

The caveat is that you must be careful to only use the money for qualified higher education expenses. Otherwise, the earnings will be taxed at ordinary income rates, and possibly an added 10% penalty. If improperly used, it becomes not such a great deal after all.

Generally, 529 Plans must be sponsored by a state. (There are a few exceptions for pre-paid tuition plans that are sponsored by a university, but from what I can tell, the use cases for those are few and far between.) Today, nearly every state has at least one 529 plan. Because of that, there are a lot of options for you to choose from. The nice thing, though, is that in most plans, you can choose a school that is not in the same state as the sponsor of the plan. So even if you invest in a Utah plan, you can still use it to pay for college in Virginia.

Currently, 33 states offer current year tax breaks for contributions to 529 Plans. You will want to check with your tax preparer, but if you are in one of those states, you should research what restrictions your state might place on your choice of 529 Plans. If you are not in one of those states, you can choose any state’s 529 Plan that best fits your other concerns. Examples of other concerns might be: investment choices, account fees, state residency requirement, or whether or not they work with your financial advisor.

Coverdell Education Savings Account (ESA)

The Coverdell ESA is another popular option. Like the 529 Plan mentioned earlier, investments in the account grow tax deferred and withdrawals used for qualified tuition expenses are tax free. Unlike 529 Plans, you can use Coverdell funds to pay for more that just college education expenses. They can be used to pay for certain elementary and secondary school expenses as well.

There are a few drawbacks with the Coverdell that could be deal breakers to some of you, depending on your goals.

The first is that there are relatively low contribution limits, especially compared to the 529 Plan. The maximum amount that can be contributed for a single beneficiary is $2,000 regardless of who the money comes from. If contributions exceed the limit for any given year, a penalty will be owed. For example, if Grandma A contributes $2,000 to a Coverdell for her grandchild and Grandpa B also contributes $1,000 to a different Coverdell for the same grandchild, a tax penalty will be owed for the excess $1,000 contribution.

The second drawback is that there are eligibility requirements for both funding the account and for utilizing some of the tax benefits. It can be tricky to make sure you are staying in line with all the rules.

UGMA/UTMA Custodial Accounts

The most flexible of the options discussed, custodial accounts under the Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) can be used for any type of college expenses, whether qualified or not, but money in these accounts can also be used for any other purpose desired by the beneficiary, such as paying for summer camp or putting a down payment on a house.

With that flexibility comes some potential issues that you should also be aware of. First, contributions become irrevocable. Once the child comes of legal age (usually 18 or 21 depending on the state of residence), the money is legally theirs and they can do whatever they want. Second, dividends, income, and capital gains in these accounts are taxed just like they would be in a brokerage account. There is no tax deferral available. Because the accounts will be in the child’s name, it is possible that earnings could be taxed at a lower rate, but that depends on the child’s and their parent’s tax situation. Third, these accounts always count in federal student aid calculations, whereas 529 Plans and Coverdell ESAs may not.

What are your options if you started saving late?

Coming soon!