Get a Head Start on College Savings

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The average amount families paid for college in 2017 was $23,757, according to Sallie Mae’s recent How America Pays for College report.

Their research shows that students and parents share nearly equal responsibility for covering college costs. While the good news is that scholarships and grants are covering the largest share of these costs in a decade (35 percent), 23 percent is covered by parents’ income or savings, 19 percent is covered by student loan borrowing, and just 11 percent is covered by the students’ income and savings.

It’s no secret that the trick to borrowing less is saving more. But college savings can actually help future college students do more than take on less debt. Children with college savings are actually four times more likely to attend.

To help you succeed in your college savings plan, you will get tips in this article.

What is a 529 Plan?
What is the Best Investment for College Savings?
How Much Should you Save for College?
What are the Risks of a 529 Savings Account?
How can I start Saving for College?

What is a 529 Plan?

A 529 plan is a college savings plan that offers tax and financial aid benefits. 529 plans may also be used to save and invest for K-12 tuition in addition to college costs. There are two types of 529 plans: college savings plans and prepaid tuition plans. Almost every state has at least one 529 plan. There is also a 529 plan operated by a group of private colleges and universities.

You can invest in almost any state 529 plan, not just your own state’s 529 plan. 529 plans can be used to pay for college costs at any qualified college nationwide. In most plans, your choice of college is not affected by the state that sponsored your 529 college savings plan.

You can be a California resident, invest in a Vermont plan and send your student to college in North Carolina. You can use your 529 plan at more than 6,000 U.S. colleges and universities and more than 400 foreign colleges and universities.

Types of 529 Plans

529 plans are usually categorized as either prepaid tuition or college savings plans.

College Savings Plans work much like a Roth 401(k) or Roth IRA by investing your after-tax contributions in mutual funds or similar investments. The 529 college savings plan offers several investment options from which to choose. The 529 plan account will go up or down in value based on the performance of the investment options. You can see how each 529 plan’s investment options are performing by reviewing our quarterly 529 plan performance rankings.

Prepaid Tuition Plans let you pre-pay all or part of the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges. The Private College 529 Plan is a separate prepaid plan for private colleges, sponsored by more than 250 private colleges.

Educational institutions can offer a prepaid tuition plan but not a college savings plan.

What is the Best Investment for College Savings?

If you’re ready to start saving for your children’s higher education expenses, then you may be wondering where you should put your money in order to receive the best benefit. Thankfully, you have a lot of investment options for college savings. Let’s look at the most popular.

529 Savings Plan

Created in 1996 and authorized by Section 529 of the Internal Revenue Code (IRC), 529 plans are legally known as “qualified tuition plans” and are sponsored by states, state agencies, or educational institutions. There are two types of 529 plans – the prepaid tuition plan and the college savings plan – and each state offers at least one type of 529 plan.

With the prepaid tuition plan, you can pre-pay all or part of the costs of an in-state public college education and lock in current tuition rates. The plan can be converted to private or out-of-state schools if your children do not choose in-state public schools, but the process to do so may be difficult.

With the college savings plans, you can invest contributions in mutual funds, index funds, or similar investment accounts that states, agencies, or educational institutions have chosen.

You are not required to invest in your home state’s plan because any 529 plan can be used to pay for qualified higher education expenses at any eligible college nationwide. However, some states offer income tax deductions or credits if you invest in your home state’s plan.

Tax Advantages

529 plans are probably the most popular way to save for your children’s educations because of the tax advantages they offer. The idea behind the 529 plans is that you make after-tax contributions into investment plans, and the interest earnings on your contributions accrue tax-deferred.

If you use the monies for qualified higher education expenses like tuition and fees, books, supplies, room and board, etc., the money is never taxed! However, if you withdraw the money for any other reason, the earnings will be subject to ordinary income taxes and a 10% tax penalty.

Like many investment plans, the 529 Saving Plan has contribution limits. Yet, one of the many benefits of a 529 plan is that contributions are considered “gifts” for tax purposes. Thus, as of 2019, you can contribute up to $15,000 per year or a lump sum of $150,000 split between two parties every 5 years without tax penalties.

Education Savings Account (ESA)

Another great way to save for your children’s college education is through a Coverdell Education Savings Account, or an ESA. Originally called an Education IRA, the ESA is a tax-deferred trust account created by the United States government to assist families in funding education expenses for beneficiaries 18 years old or younger.

Much like 529 plans, ESA’s grow tax-deferred, and you can withdraw your contributions and earnings for qualified college education expenses tax-free! An added bonus to these types of accounts is that you can withdraw the monies tax-free for qualified elementary and secondary education costs as well.

Additionally, you can invest in almost any security – stocks, bonds, and funds – rather than being limited to funds.

Unfortunately, the maximum contribution limit for an ESA is much lower than the limit for 529 plans, topping out at $2,000 per child per year, and they are only available to families who fall under a designated income level. Nevertheless, they can still play a valuable role in your college savings plans.

Unified Transfer to Minor Act (UTMA)

If you aren’t sure whether or not your child will attend college, an UTMA account might be the right investment option for you.

The Unified Transfer to Minor Act is a custodial trust savings account which is used to hold and protect gifted assets for minors until they reach the age of maturity in their states (usually 18 or 21). UTMA accounts allow minors to own cash securities. They can own real estate, fine art, patents, and royalties.

Since the IRS allows exclusions from the gift tax up to $15,000 annually for qualifying gifts to minors, a person can contribute or “gift” up to $15,000 per year into the UTMA account. Assets are then counted as part of the custodian’s taxable estate until the beneficiary takes possession at age 18 or 21.

At that time, beneficiaries can withdraw and use the assets for any purpose. They are not required to use the money for college expenses. However, since the account and its assets are in the child’s name, the government may be reticent to issue financial aid to the beneficiary of the assets for college expenses.

Cash Value Life Insurance

The next investment vehicle, a cash value life insurance plan, may not top your list for college savings plans. However, the funds in the insurance savings plan grow tax-deferred, and you can withdraw portions of the cash value for any purpose.

That buildup in funds can help offset college costs, especially if you’re looking to bypass the restrictions of a 529 Plan or an ESA or you don’t want to deal with the taxation that accompanies a UTMA.

If you go this route, though, you’ll definitely want to work with advisors who will help keep the policy from being commission-heavy. They can help you find a policy with the highest premium allowed and the lowest death benefit.

However, you have to be careful with these… you don’t want to pass the modified endowment contract (MEC) threshold. That means if you put too much into the life insurance premium, the IRS will say you’re not using this properly as an insurance policy.

When you take the money out, they’ll tax you on it. If that happens, you’d want to take the money and put it into a UTMA. So it is possible to receive a better rate of return if you set it up right.

ROTH IRA

Another unconventional way to save for your children’s college education is through a Roth IRA. Many times, I hear people tell me they can’t fund their retirement, pay down their debt, AND save for college. That’s where a Roth comes into play. You can save for retirement and pay for your kids’ college educations with after-tax money you invest!

Obviously, Roth IRAs are typically used for retirement purposes. However, the IRS will let you withdraw money tax and penalty-free if you follow a certain set of rules. You are able to withdraw your contributions to the Roth IRA at any time.

If you desire to withdraw the earnings, then the earnings must have been in the account for five years. If the earnings have been in the account for 5 years and you are over the age of 59 1/2, then you can withdraw the funds tax and penalty fee.

However, if you are under the age of 59 1/2, you will want to limit your withdrawals to your contribution amounts to pay for higher education expenses and avoid penalties. Just remember, the more you withdraw for your children, the less money you have for your own retirement.

How Much Should you Save for College?

The price of college is rising—the cost of college has grown faster than the overall basket of goods and services that people generally buy since 1980—and there’s a host of other unknowns to plan for. Should you choose a public or private university? Should you stay in-state or go out of state? Could your child get scholarships? What about grad school?

Luckily, you don’t need to know the answers to all these questions to start saving. Here are a few of the most helpful strategies for deciding how much to save for college.

Choose an End Goal

One of the most common ways to set a savings goal is based on the projected cost of college. It helps to start by using one of the calculators out there to help you estimate the cost of college for your child, based on factors like your child’s age, the type of school you expect your child to attend, and the expected rise in the cost of college.

You should also consider whether there is a specific school that you already know your child wants to attend.

Getting a little sticker shock? The good news is that whether you’re saving for in-state, out-of-state, or private, you don’t have to plan for the whole amount.

Many financial advisors instead recommend saving about one-third of the cost of college, with the expectation that the rest will come from financial aid, scholarships, and current parent and/or student income. This can make the goal of saving for college feel more realistic and achievable.

For example, let’s that you just had a child and you’re ready to start saving now. In order to pay a third of the projected cost of college, your end goal might be $73,700 for a public in-state university, $116,800 for a public, out-of-state school, and $145,100 for a private college.

**Set the Right Monthly Goal**

Is it a little too difficult to imagine the end goal, years from now? Consider walking it back to a monthly contribution amount. Just remember that how you save will make a big impact on how much you save by the time your child starts college.

Many experts recommend using a 529 college savings plan, a tax-advantaged investment account. A 529 plan offers tax-free growth and withdrawals for qualified higher education expenses, which include tuition and fees, room and board, books, computers, and special education expenses.

What does this mean for you? Choosing a 529 plan could mean a much lower monthly contribution since the money grows over time. With a 529 plan, solid monthly contribution amounts for a child born in 2017 would be about $165 for a public in-state school, $260 for public out-of-state, or $325 for a private university.

If you intend to save using a traditional savings account or a taxed investment account, you’ll want to adjust your monthly contribution accordingly. For example, the average interest rate on savings accounts as of June 2020 was 0.06% APY (annual percentage yield).

At that rate, in a savings account, you’d need to contribute about $300 per month for 18 years to pay for a third of the projected cost of a public, in-state college; around $500 for out-of-state; and around $600 per month for a private university. Nearly double the required savings compared to a 529.

Using a taxed investment account can yield significantly better returns on your savings. With an average 7% return, a monthly contribution of about $190 would cover the projected cost of a public in-state university, $300 for out-of-state, or $390 for a private college. However, you will miss out on the 529 plan’s tax exemptions on dividends and gains.

Decide Based on What You Can Afford

Lastly, you can set a monthly savings goal for college based on what your family can afford. This is a good approach if there’s not much wiggle room in your budget.

Of course, what’s affordable will vary widely from one family to the next. If you’re not sure what’s doable for your family, try breaking it down using the Lumina Foundation’s Rule of 10 formula.

Though originally intended as a benchmark for colleges seeking to expand access to higher education, the formula can certainly be utilized by families. This approach recommends that families pay for college using the benchmarks:

Families save 10% of their discretionary income;
Families save over a period of 10 years; and
Students work 10 hours per week while attending college.

Discretionary income is typically defined as total after-tax income, minus all minimal survival expenses such as food, medicine, housing, utilities, insurance, transportation, and so on.

The Lumina Foundation states that for the purposes of these benchmarks, any income above 200% of the federal poverty level is “discretionary.” For a family of four in 2020, that would be any income over $52,400.

Following this formula, a family making an average of $100,000 annually might save 10% of the remaining $47,600, or $397 per month. Over 10 years, that’s nearly $48,000 saved for college. With a student working 10 hours per week for 50 weeks per year at the current $7.25 minimum wage, that’s an additional $3,625, for a total contribution of $14,500 over four years.

Of course, if your income increases or decreases, your contributions can be adjusted accordingly. And you can always make this methodology go farther by using a tax-advantaged savings tool to grow your money over time.

For example, if a family with an 8-year-old child began saving $397 per month in a 529 savings plan, that amount would grow to be enough to cover the third of costs that experts recommend for a public-out-of-state school or about half the cost of an in-state university.

What are the Risks of a 529 Savings Account?

If you’re thinking about opening a 529 plan for a child or grandchild, it’s important to understand 529 plan rules and how they work. Here are some advantages and potential disadvantages of 529 plans to consider.

Pros of using a 529 plan to save for college

529 plans offer tax-advantaged savings for education

529 plan investments grow on a tax-deferred basis and distributions are tax-free when used to pay for qualified education expenses, including college tuition and fees, books and supplies, some room and board costs, up to $10,000 in K-12 tuition per year and up to $10,000 in student loan repayment per beneficiary and per sibling.

Qualified 529 plan distributions are also excluded from state taxable income, and many states offer a state income tax deduction or state income tax credit for 529 plan contributions.

529 plans are low maintenance investment accounts

A 529 plan account can be opened online or through a licensed financial advisor. Families who prefer to “set it and forget it” can select an automatic investment plan linked to a bank account or payroll deduction plan. The ongoing investment management within a 529 plan is handled by the program manager.

529 plans have high maximum contribution limits

Unlike a Roth IRA or Coverdell Education Savings Account, 529 plans have no annual contribution limits and high aggregate limits. Maximum aggregate limits vary by state, ranging from $235,000 to $529,000.

529 plan contributions are considered completed gifts for tax purposes and up to $15,000 qualifies for the annual gift tax exclusion. There is also an election to contribute as much as $75,000 in one year without generating a taxable gift if the contribution is treated as if it were spread over five years.

Parent-owned 529 plans get favorable financial aid treatment

529 plans owned by a dependent student’s parent or a dependent student are reported as parental assets and have a relatively minimal effect on financial aid eligibility. Distributions from a 529 plan owned by a dependent student’s parent or a dependent student are not counted as income on the Free Application for Federal Student Aid (FAFSA).

529 plans are flexible

529 plans offer the same benefits for all families, regardless of their household income or the amount they contribute. You can invest in almost any 529 plan, no matter where you live or where you child will attend college.

Cons of using a 529 plan to save for college

529 plan funds must be spent on qualified expenses to avoid tax and penalty

Non-qualified distributions are subject to income tax and a 10% penalty on the earnings portion of the distribution. However, there are exceptions to the penalty if the beneficiary gets a scholarship, attends a U.S. Military Academy, dies or becomes disabled.

State income tax benefits may be recaptured if you switch 529 plans

If a 529 plan account owner does a rollover into another state’s 529 plan, any state income tax deductions and credits previously claimed may be subject to recapture, and the earnings portion of the outbound rollover may be added back to state taxable income.

Some 529 plans offer limited investment choices

A 529 plan account owner must select from a menu of investment options offered by the 529 plan. This typically includes static investment portfolios that aim to achieve a targeted level of risk, individual fund portfolios and age-based portfolios that automatically shift asset allocation as the beneficiary gets closer to college.

Some 529 plans have high fees

The more families pay in 529 plan fees, the less they are able to save for college. Direct-sold 529 plans are less expensive than advisor-sold 529 plans, but expenses can also vary among 529 plan portfolios. It’s important to research your options and find a low-cost 529 plan option that meets your college savings needs.

529 plans owned by a third-party can hurt financial aid eligibility

A 529 plan owned by a grandparent or anyone other than the student or parent is ignored on the FAFSA (but may be considered on the CSS Profile). However, distributions from a 529 plan owned by a third-party are counted as untaxed income to the student and can reduce the student’s eligibility for financial aid.

To avoid this negative impact, grandparents can time the 529 plan distribution so that it is not counted on their grandchild’s FAFSA.

How can I start Saving for College?

Put Money Into Eligible Savings Bonds

“If you redeem them and use the money to pay for higher education, excluding room and board, you can exclude the income from their annual gross income for tax purposes,” says Ryan Eyerman, an accredited asset management specialist and financial advisor at E&M Consulting in Strongsville, Ohio.

“This is of course subject to certain restrictions,” Eyerman adds.

Some of the advantages of putting money into savings bonds is that they’re guaranteed by the government and extremely low to no risk. On the downside, the interest you’ll earn is pretty low. Right now, individual Series EE savings bonds are earning an annual fixed rate of 0.10%.

Try a Coverdell Education Savings Account

These, Eyerman says, are “a tax-deferred trust account that can be used to pay for elementary, secondary and higher education expenses – room and board is permitted. Earnings accumulate tax free, and distributions are free of income taxes as long as the funds are used for educational purposes.”

Just make sure your kid isn’t a permanent student who plans on graduating … well, someday.

Eyerman adds: “All funds must be used by age 30, or there may be tax penalties.”

Take Out a Permanent Life Insurance Policy

This is a college savings plan strategy typically used by higher net worth families to provide tax-advantaged savings for multiple goals, including higher education, according to Bryan Bentley, a financial advisor who owns Bentley Financial in Roseville, California.

A permanent life insurance policy is a conventional life insurance policy, but some of the money from your premium goes into the death benefit, and some of the money goes into a tax-deferred savings account.

One of the pluses of doing this, Bentley says, is that the money you save “can be accessed at any time for any reason, so it is not limited to college expenses. It provides additional benefits such as a death benefit, and other living benefits, and there is no adverse impact if it is not used for education expenses.”

He adds that the life insurance policy doesn’t count as an asset when you’re looking for financial aid from a college.

Still, this is the type of saving for college plan that you’d want to discuss with a financial advisor. For instance, there are upfront and recurring fees that might make you think twice before doing this.

Take Out a Home Equity Loan

“This is a common approach, whether intentional or not,” Bentley says. “The equity in a family’s home is often their largest asset, so it is often used to cover college costs. Some families will choose to pay down a mortgage instead of creating a separate college savings plan with the intention of tapping the equity if financial aid or scholarships do not materialize.”

Of course, you probably weren’t intending to use your home equity to pay for your kid’s college – and with a loan, you’ll have to pay that back.

So as a college fund for kids strategy goes, it’s not really the best approach – if you still have years in which you could be saving money for future education costs. But if you haven’t saved enough and are looking for a way to pay for tuition, not to mention room and board, it may work out well.

But that’s why you want to start early – so you don’t have to take out as many loans – and as with any investment but especially with college savings plans, it’s always best to begin putting aside money as soon as you can. You always want to try to start your investments yesterday as opposed to tomorrow.

Start a Roth IRA

But wait, isn’t that for retirement? Typically, yes, but it doesn’t have to be, according to Laurence Namdar, a financial planner and the founder of Asher Levi Financial, a registered investment advisory firm in Holly Hill, Florida, a suburb of Daytona Beach.

“A Roth IRA is an excellent vehicle for many taxpayers to invest after-tax dollars while shielding earnings and future growth from taxes forever, as long as appropriate distributions are made,” Namdar says.

As with any investment, you want to look at the pros and cons carefully – for instance, other relatives can contribute to a 529 but not a Roth IRA. If you have one, you’ll obviously want to discuss this with your financial advisor.

But one big selling point, says Namdar: “With a Roth IRA, should a child decide not to attend college, the parents already have those funds invested for their retirement.”

Put Money Into a Custodial Account

In other words, savings accounts called UGMAs and UTMAs (Uniform Gift to Minors Act and Uniform Transfers to Minors Act). They’re both virtually the same thing but UTMAs can hold assets beyond cash, stocks, mutual funds and so on, like a UGMA – but also real estate.

There’s no limit in how much money you can put into a UGMA or UTMA, but this is best with a child whom you believe is responsible. Your child will legally be able to use the money in the account – for college or anything else – when they turn 18.

Invest in Mutual Funds

There’s no limit on what you can invest, and of course, you don’t have to use the money for college. But what you earn will be subject to annual income taxes, capital gains will be taxed when shares are sold and the mutual fund’s assets can reduce financial aid eligibility.

Conclusion

While it’s easy to get sticker shock from skyrocketing college costs, remember that the amount you need to save is likely much lower.

The important thing is to start as early as possible and to be consistent with saving. However, if your child is older, don’t panic—you can still save a significant amount in a shorter time frame.

Financial aid, scholarships, student work, your income while your child is attending college, and contributions from family can all help to make up the rest.