The perfect preschool? Check. Feeding into the ideal elementary school? Check. Excellent high school, giving them the best chance at their dream college? Check. College tuition? Gulp.
As parents, we all want the very best for our children, and that includes higher education. But the cost of college has skyrocketed over the years. The College Board reports that a “moderate” college budget for an in-state public college for the 2014–2015 academic year averaged $23,410. A moderate budget at a private college averaged $46,272.[i] On top of that, the average cost of room and board in 2014–2015 ranged from $9,804 at four-year public schools to $11,188 at private schools. And the cost of college has been rising about 2-4% every year. These are daunting figures for any parent. But don’t let fear paralyze you.
How much do you need to save?
Remember the story of the tortoise and the hare? When it comes to college savings, we should all try to be the tortoise. Starting as soon as possible, with slow and steady savings, is the way to finish strong in this race. Everyone has heard this mantra before, yet many avoid formulating a real plan. But just getting started can sometimes be the hardest part. Perhaps trying to save the full amount is too overwhelming. Maybe an ultimate goal of paying say 75% of the cost (and your child covering 25%) is more within reach and more likely to get you saving. Financial aid, scholarships and loans can bridge the gap.
How to save?
529 Plans. We’ve all heard of them, but what are they? 529 plans are college savings vehicles offered by different states. They operate much like a mutual fund in that the plan will invest in stocks and bonds and aim to grow faster than a regular savings account. The big bonus here is that any appreciation earned grows free of income tax — forever. This is an enormous benefit over a regular mutual fund which would be subject to capital gains when you sell. Some have “aged-based” investment options so depending on your child’s age, the level of risk adjusts, automatically becoming more conservative as the child reaches college age. The other nice thing about the 529 is that it is sort of a “forced savings” plan in that the money you contribute cannot be used for anything other than higher education. So if an unexpected bill comes up, or the urge to splurge on a vacation arises, the 529 money is not available (without paying some hefty penalties).
You can contribute as much or as little as you like, and you can choose any state. You are not restricted to your home state although some states offer income tax deductions for their residents. You can use the money for different beneficiaries so long as it’s for college so you need not set up separate 529 plans for each child. Make sure you research each plan to understand the level of risk, investment mix and recent performance.
Downsides to the 529 Plan
For most folks, especially those starting to save early while the children are young, 529 plans make a lot of sense and offer many advantages. However, it’s important to be aware of some potential drawbacks. First, you must use the money for educational expenses for any post-secondary school (college or graduate school). This includes tuition, books, uniforms and even transportation. If the money is not used for a qualified expense, you will have to pay income tax plus a 10% penalty. But as discussed earlier, this could be viewed as a positive because it forces discipline.
Second, 529 plans could affect your financial aid eligibility. For federal financial aid purposes, 529 plans shouldn’t impact eligibility too much since the assets within a 529 plan are considered parents’ assets, and are counted at a rate of only 5.6% (as opposed to custodial accounts or UGMA’s, which are counted at a rate of 20%). However, individual schools and scholarships are a different story, and depending on their calculations, 529 plans may decrease available aid. For this reason, it may make sense to put some savings in a Roth IRA, which also grows income tax free, but is ignored from financial aid calculations because it is a parent-owned retirement account. For most people, both college and retirement are hugely important savings goals, so it’s wise to balance the needs of the whole family.
Lastly, 529 plans do restrict your investment options so you will have less flexibility than a regular mutual fund. Also, many charge fees for managing the plan, anywhere from one tenth of one percent to 2%. Still, since all the growth of the assets inside a 529 plan is exempt from income tax forever, it is difficult to outperform a tax-free return, even with the most aggressive investments. However, some people simply do not like the idea of having their investment options restricted in any way.
Regardless of the savings vehicle, try not to “freak out” and become paralyzed. The key is to start saving as early as possible, and try to stick to a plan! For more information, visit: savingforcollege.com.