Saving for College – A Comprehensive Guide

In today’s day and age, getting a college degree is essential and much needed to stay ahead of the competition. However, the average cost of a 4-year public college degree in 2020 is just a little over $100,000 and keeps rising rapidly. 

As a parent, saving for college, especially if you have more than 1 child, is not an easy undertaking. For many people, it will seem impossible to save enough. After all, parents do not want their children to start their lives with a crippling amount of debt. So, instead of feeling in despair, there are several ways to save for college without having to skip a meal. 

Infographic that explains what to do before you start saving for college, that the earlier you start investing, the better, the cost of a 4-year in-state public college is a little more than $100,00, and the different accounts and plans that are available for college savings and investments.

When Should You Start Saving for College?

The earlier you start saving for college, the better. It is easier to reach your long-term goals, thanks to the power of compounding. When you re-invest your investment earnings, those earnings can then produce earnings of their own. Thanks to the power of compounding, even a small amount of savings can grow into a significant amount of money. Some parents start saving even before they have children. 

However, you should not start saving for college if you have any outstanding high-interest debt, such as credit card debt, or have no money set aside for an emergency fund. It will be best if you get rid of that high-cost debt first and start an emergency fund. In the meantime, if you can afford to save a small amount of money above and beyond that, you should. 

Before saving for college, it is essential to get your personal finances in order. This includes careful consideration of taking out new loans.  If you need to take out a loan, you need to ask yourself whether it is a crucial purchase or do without it for a certain time.

Besides saving for college, you need to start saving for your own retirement. Although retirement might be further away than sending your kids to college, you need to keep in mind that while you can borrow for college, you may not have the means to borrow for retirement. After all, you do not want to be a burden to your children later on. Especially while they may have their own financial obligations to deal with it. So somehow you will need to balance saving for your retirement and saving for your children’s college education. 

However, you need to consider several important factors that might affect the amount of money you need to save. For example, your child’s eligibility for financial aid. This will mostly depend on your income as a parent or your child’s income if your child is working, possible scholarships, what type of college (private or public), and the percentage you as a parent are able and willing to contribute. 

Please note that saving for college will not hurt your child’s eligibility for financial aid. The federal government bases your expected contribution mainly on your income and not so much on your savings. As long as you are not withdrawing money from retirement accounts they do not hurt your child’s eligibility.  

Once your finances are in order and you have made your plan, start saving for college immediately. In fact, as with any investment, the earlier you start, the more time your money has to grow. If you have decided to save for your children’s education, start saving when they are born or even before they are born. 

If you will save for your own college education, start saving as much as you can when you start making money. Then, opt for an account with tax benefits. This way you will still have time to take advantage of the tax benefits.

How Much Should You Be Saving for College?

College is costly and saving enough is not an easy task.

The total cost of college at a 4-year in-state public university is on average $25,396 in an academic year. Or $101,584 over 4 years. The total cost of college includes tuition and fees, books and supplies, room and board for those students living on campus, and additional expenses. A 4-year out-of-state public college is on average $42,514 per year or $170,056 over 4 years.

The total cost of college at a four-year private university is, on average, $53,102 per year. Or $212,408 over 4 years.

Please note that most people do not pay the full amount at the more expensive private colleges as your child may qualify for more financial aid. With this in mind, it might seem like a daunting task to begin saving for college. But with dedication and hard work, it is possible to save the money you need to pay for college.

Yes, college costs are rising every year. However, you do not need to save the full amount unless you really want to and can. To make things more manageable, most financial planners recommend saving about one-third of the expected costs. Current income and future income, grants, and loans can take care of the remaining two-thirds over your child’s lifetime.

Please note that the average student debt in 2020 is a whopping $37,584. Student loan debt in the United States totals $1.68 trillion and grows 6 times faster than the nation’s economy. These are staggering numbers, and at this stage, college graduates will be lucky to have their student loans paid off, even before their kids start college.

Infographic that explains and shows that saving for college now is much better than borrowing for college later.

As student loan debt continues to grow, it is crucial to understand why saving for college ahead of time can be such a money-saver in the long run. The above graphic shows the difference between money spent for a four-year in-state public college education when saving in advance versus taking out loans when the money is needed.

The example assumes that the total expected cost for a 4-year in-state public college is $100,000. When saving in advance, the assumption is made that you start saving at your child’s birth and continue saving for 18 years. Another assumption to consider is that the average return on your investments is 5% per year for 18 years. This means that you will have to start saving $286.36 per month to get $100,000 after 18 years. The total amount of money spent in this scenario is $63,291.

Another option to pay for college is to take out a loan for the $100,000 when needed in 18 years. Assumptions are that the annual interest rate is 5%, and the loan needs to be paid off in 18 years. The total amount paid for the $100,000 loan after 18 years is $151,855 or $703.03 per month.

This example shows that you can save $88,564 for a $100,000, 4-year college education when you start saving at your child’s birth versus taking out a loan when your child starts college. This clearly shows that the earlier you start saving for college, the better. This also shows that compounding returns make money grow faster. Even a small amount saved each month can add up, thanks to compounding interest working for you.

To determine how much you will be actually paying for college, you will need to research the projected costs of the desired public or private university where your children will be attending. Based on historical college cost data, the cost of a college education has roughly tripled over any 18-year period from birth to college enrollment. However, in the last few years, the rate of increase has slowed down a little bit. If the current trend continues, it will be a little bit more than double today’s cost.

With this in mind, you can take the cost of the preferred college in the year of your child’s birth, multiply that number by 2 or 3, and then you should have a reasonable estimate of the total amount of money needed when saving for college. Then, based on what percentage of the total cost you want to save and invest for college, you can calculate how much you would have to invest or save monthly. Of course, if this is getting too complex, you can always hire a financial advisor to plan for you.

529 Plan Details

529 plans, or Qualified Tuition Plans (QTPs), are state-sponsored education savings plans. They are tax-advantaged investment accounts designed to encourage saving for college and other education costs. They are sponsored by states, state agencies, or educational institutions. The 529 plan account funds can be used to pay for qualified education costs, including tuition, room and board, and college books. However, the money cannot be used for general livings expenses. 

The funds can also be used for qualified costs for private K-12 schools, graduate school, and apprenticeship programs. In addition, these 529 plans allow federal tax-free withdrawal of earnings. In addition, dependent on the state, possible state income tax deductions might be allowed as well. Plan contribution limits vary from state to state and range from $235,000 to $529,000.

Every state’s 529 plan is available to the public, regardless of residency.

How do they work?

529 plans function similarly to Roth IRAs. They allow parents, students, or pretty much anyone to invest after-tax money into diversified, low-cost stock and bond funds. The funds can then be withdrawn tax-free for any qualified education expenses for the beneficiary.

What are the different types of 529 plans?

There are two types of 529 plans: college savings plans and prepaid tuition plans.

College Savings Plan: This plan functions similarly to the Roth 401(k) or Roth IRA account but has higher contribution limits. The majority of these college savings plans offer a variety of mutual funds as their investment options. Anybody, even non-family members, can contribute after-tax funds to a 529 college savings plan. The account value will go up or down based on the performance of the investment options the account owner selects.

Prepaid Tuition Plans: Prepaid tuition plans let you pre-pay all or a part of the costs of attending a specific university, or a group of institutions participating in a particular plan, to avoid future tuition hikes. These state plans let you basically “lock in” tuition costs. The private prepaid college 529 plan is a separate plan for private colleges sponsored by more than 250 private colleges. 

With the fast increase in college costs, many states have realized that it is “too good a deal” to offer a pre-paid tuition plan. So, most states have stopped taking any new applications. As a result, only 10 are currently accepting new students. 8 of them have an in-state requirement, which makes saving for college a little harder.

What are the pros and cons of a 529?

Infographic that explains the pros and cons of a 529 education savings plan.

The pros 

Tax-deferred growth – The biggest benefit of 529 plans is the tax breaks these plans offer on the gains earned. When the funds are used to pay for qualified tuition expenses, no federal taxes need to be paid on the gains of the investments.

Income-tax free distributions – No taxes are due at distribution, as long as they are used to pay for qualified expenses. The following expenses are considered qualified expenses: tuition and fees, books and supplies, laptops, printers and internet service, room and board, and some off-campus living expenses. Expenses such as cell phones, travel expenses, and health insurance are not eligible expenses.

Contributions are considered gifts – As soon as your child is born, you can open a 529 plan. If you have access to an employer-sponsored 529 plan at work, you can consider that instead. Contributions are considered gifts to the beneficiary and can generally be up to the gift tax exclusion, which in 2020 is $15,000 ($30,000 for gifts from a married couple) without using up part of their lifetime gift tax exemption. 

Tax-free rollovers to other qualifying family members – If your child never goes to college, the beneficiary of a 529 plan can always be changed. 

Can be used for some other educational expenses besides college – As per the Tax Cuts and Jobs Act of 2017, parents can also use this plan to fund some non-college expenses. For example, these savings can be rolled over into an ABLE account to cover disabled children and young adults’ expenses. It can also cover a part of the tuition for K-12 students attending a private school. It can even be used for grad school. 

High Contribution limits – 529 plans have an aggregate limit that ranges from $235,000 to $529,000, depending on what state it is in.

No income-based phaseouts – Anyone, even high earners, can contribute and receive available tax breaks. The account must be held in your child’s name.

Seed money/matching contributions for low-income families – Another benefit that is sometimes offered is that some state plans offer seed money after a first child is born or adopted to encourage saving for college. Other states may provide matching contributions for low and moderate-income families.

Automatic contributions – Most 529 savings plans allow you to set up automatic, recurring contributions. This makes saving for college very easy.

Ready-made target-date-like portfolios – To make things even easier, some 529 plans offer ready-made portfolios that work like target-date funds. As such, they provide a complete portfolio of stock and bond funds that will automatically become more conservative as you approach the date your child’s first tuition bill is due. 

The cons 

Some withdrawals are subject to income tax and a 10% penalty. Qualified expenses include college tuition, books, fees, supplies, and room and board. Money spent on unqualified expenses is subject to income tax to the IRS and a 10 percent penalty on earnings. 

Limited investment options – There are restrictions on how money in these plans can be invested. 529 plans offer different investment portfolio options, including various mutual fund and ETF portfolios and a principal-protected bank product. In addition, investments in this plan can only be switched twice a year.

Exposure to market volatility – Another important disadvantage is that the funds in the 529 plans are exposed to stock market volatility. This can negatively impact returns in a bear market and become a problem when it gets time to start withdrawing funds. Therefore, it is essential to monitor the risks being taken, especially as the withdrawal date nears.

Fees and expenses might be high – This depends on what plan is selected.

How to invest or select the right 529 plan when saving for college?

States run the 529 plans, and in 2020, almost every state offered its own plan, except Wyoming. Wyoming has adopted Colorado’s 529 plan offering. The state plans vary widely in their costs and quality. Only 34 states, plus the District of Columbia, offer a state tax benefit on contributions to the plans. It is often wise to start by looking at the 529 plans in your home state first, as some states will only offer state tax benefits to in-state residents.

So, what is the best 529 plan for saving for college? Here are some criteria to consider before selecting which state plan is the best for you:

  • Performance: Know the annual return on investment for the 529 plan
  • Cost: Look at the fees charged by the 529 plan in terms of sales charges and asset-based expense ratio. 529 plans sold through a broker generally have higher annual costs and include sales charges. These charges can be anywhere from 1 percent to 5.75 percent of your contributions. 
  • Sold plans: Consider direct-sold and advisor-sold plans. While the former tends to charge low fees, the latter may have lower annual expense ratios.
  • Tax benefits: Earnings in this plan can accumulate on a tax-deferred basis. Distributions from this plan are also tax-free if used to pay for qualified higher education expenses. Some states do not offer state tax benefits.
  • Investment options: Each plan offers a limited selection of investment options, varying with each plan. While some may offer a static and multi-fund portfolio based on passive index funds, others offer portfolios based on actively managed funds.

Other Choices for College Savings

While there are definite pros and cons to the 529 plan, people can use other accounts when saving for college. Doing your own research or hiring a financial advisor will give you a better idea of what types of accounts to use when saving for college. Here are some of the most common alternatives to 529 plans you can use for your college savings plan.

Traditional Savings Account

Many Americans use regular savings or checking accounts to set aside money for their children’s education. 

Pros: If you don’t want to use the funds for college or educational purposes, you can use the funds for any other purpose without incurring a penalty or fine. You can also get a small ROI with this account, especially if you open one as early as possible. A savings account is one of the safest places to keep your money because it is insured by the Federal Deposit Insurance Corp. (FDIC). So, even if your bank goes belly up, you will get your money.

Cons: Interest rates on a savings account are very low. This makes it challenging to meet your “saving for college” goal. Furthermore, easy access to funds also makes it difficult to save. Often funds get used for other purposes to replenish them in the future, but that does not always happen.

Roth IRAs

Roth IRAs are long-term Individual Retirement Accounts. Contributions are made using after-tax funds, but the savings in a Roth IRA grow tax-free. Withdrawals from this account will be tax-free after the age of 59 1/2.

Pros: Early withdrawal will normally trigger a 10% penalty. However, you can withdraw funds before 59 ½ years without penalty if the money is used for qualifying purposes such as educational expenses. Your money must be in your account for at least 5 years to avoid an early withdrawal penalty. If your child decides not to go to college, your funds can stay in your account as retirement savings.

Another advantage of using Roth IRAs when saving for college is that they offer various allocation choices. You have the option to select stocks, bonds, mutual funds, and Exchange Traded Funds (ETFs).

Cons: These accounts have contribution limits. Additionally, since they are mostly designed for retirement purposes, they come with rules and regulations.

Coverdell education savings account

Education Savings Accounts (ESA) are an alternative to 529 plans designed to help families save for college and cover elementary and secondary education expenses, including private school tuition.

Pros: They offer a wide variety of available investment options and tax-free growth.

Cons: ESA accounts have contribution limits and income restrictions. As of December 2020, you can only contribute up to $2,000 per year to these accounts. If your modified adjusted gross income is higher than $110,000 (or $220,000 on a jointly filed tax return), you can’t open one of these accounts. Assets in these accounts are required to be distributed by the age of 30.

UGMA or UTMA Accounts

These accounts are custodial accounts and are regulated by the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). A custodial account is a financial account held in a minor’s name. This is usually a parent, legal guardian, or another relative. This allows the adults to save for the minor while retaining full control of the account until adulthood. Many asset classes are available, including bank deposits, stocks, and real estate

Pros: Your federal income taxes can be lowered by transferring any income-producing asset to your child under 18 years old. There is no upper limit on the contribution amount to this type of account. However, if you contribute more than $15,000 per year or $30,000 for a married couple filing jointly, you will need to pay the federal gift tax.

Cons: All asset transfers to these accounts are irrevocable. Money in these accounts can also affect your child’s ability to qualify for financial aid. This is especially true if they want to apply for a student loan in their own name. Besides, once the child becomes an adult, they can use the money for whatever they want. 

Treasury Bonds 

A treasury bond is like an IOU. It is an agreement between the US government and the investor in exchange for the original deposit, plus interest when the bond matures.

Pros: This is a solid option for those who do not want to take risks when saving for college. In fact, interest earned on new Series EE Bonds and Series I Bonds is tax-free when it’s used to cover qualified education expenses, or the savings are transferred to a 529 plan.

Cons: There is limited gain with treasury bonds. Moreover, not everyone would be qualified for favorable tax treatment under this account as there are income limitations for High-Net-Worth Individuals (HNWI).

Trusts

These are educational trusts, structured as UGMA or UTMA accounts, set up on behalf of a child, where assets are transferred to the child’s account and invested until the child reaches adulthood (18 or 21 dependent on the state). 

Pros: Trusts offer more flexibility as funds from the trust can also be used for other purposes besides education. Additionally, they can offer tax advantages to the donor.

Cons: Taxation rules can differ based on the kind of trust you are setting up. It can also reduce the child’s future financial eligibility for aid or any financial assistance. Another disadvantage of trusts is that as soon as the beneficiary becomes an adult, they can use the money for whatever they desire, not just education.

Conclusion

As with other kinds of investing, the earlier you get started when saving for college, the better. The safest bet to reach your goals is to start saving for college when your child is born. This gives you a time frame of about 18 years before those funds are needed for college and time for the money to grow.

There are many college savings options available these days, so it should be possible to develop a plan that fits your specific situation and your saving for college goals. 

The most obvious choice is to contribute to a 529 plan. This is a tax-advantaged investment account designed to encourage saving for future education costs. 529 plans have been very popular as they are tax-efficient and offer an easy and flexible way to start saving for college. There are 2 types of 529 plans.

With a 529 savings plan, your money can grow considerably depending on how your investment portfolio performs. However, please note that it is possible that the value can drop during a stock market downturn. Luckily the investment portfolio is set up to get more conservative as your child gets closer to college age.

With a 529 prepaid plan, you’re locking in tuition prices by prepaying for college credits. Given that tuition prices have been increasing rapidly, a prepaid plan allows you to pay much less for tuition than you would in the future. Unfortunately, a lot of these prepaid plans are being phased out.

Besides a 529 plan, there are many other options when saving for college. For example, it might be a good idea to use a combination of different accounts depending on your long-term goals and personal financial situation.

In general, options that include investments in the stock market, such as 529 plans, and Roth IRAs, will give you a higher return over the long term. However, they are riskier. Putting your money in regular savings accounts and CDs generally is not a great idea for the long term because the interest rates are usually very low.

Whichever method you choose, make sure you do the research to completely understand your options and how your decisions will affect your financial future in the long term. If you feel uncomfortable with your decision or do not have the time to explore your options, you can always hire a financial advisor to help with your college savings plan.

Finally, always evaluate your plan regularly to ensure you are still on track to meet your college savings goal. Remember, every little bit you save now will reduce your child’s potential future student debt.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.