Each year, college expenses grow at about twice the rate of inflation. According to the Scholarship Workshop, the average cost of attendance – including tuition, room, board, books, travel, and miscellaneous expenses – at a four-year public institution for the 2014-2015 school year weighed in at $29,110. The average cost at a four-year private university was $62,740. With an approximate 8% increase in tuition per year, it’s possible that college for your infant will be up to three times today’s costs in 18 years. Many parents will agree, that knowing ways to save for college now is important, and indeed vital, information.
The good news is that you can be view these costs as the published “sticker” price. When the time arrives for your child to apply for college, your financial situation and your child’s accomplishments may whittle down some of that cost with financial aid and scholarships. However, since you have no crystal ball and are unable to truly know what your financial situation will be or whether your child will rake in merit scholarships, your responsibility lies in determining what to contribute to your child’s college education and starting now if you haven’t already begun saving.
A common recommendation is to follow the “one-third rule,” which suggests that you pay one-third of the expected costs with savings, one-third with current income and financial aid while your child is in school, and the final third with parent and student loans. You could also consider setting a goal to save 100% of the cost at a state university, which would be almost half the cost of a private university.
Once you decide how much you are going to save for your child’s college education, you will need to determine what savings vehicles you will use. Here are four ways to save for college:
1. 529 Plans
The most popular method of college savings is with a 529 Plan. Named after Section 529 of the Internal Revenue Code that started these savings plans, every state offers at least one program which allows you to save for college and withdraw that money tax-free for eligible college expenses. There are no income limits on 529 plans, so anyone can invest in them. There are two types of plans:
Savings Plans are similar to IRAs, in that you contribute after-tax dollars to the account, and that money is invested, typically in mutual funds. You own the savings plan and designate your child as the beneficiary, and you retain control of the funds while your child is in college. You are able to open a 529 savings plan located in any state, but you may benefit from a deduction on your state taxes if you invest in your home state’s plan. A few states, however, offer state tax deductions regardless of which state’s program you participate in. Funds from a 529 plan can be used nationwide at eligible institutions.
Pre-Paid Tuition Plans allow you to save up to the full cost of an in-state public college’s tuition. Depending on the plan, you invest a contracted amount over time and lock in your child’s future tuition costs. If necessary, the plan can be converted to a specified dollar amount to pay for out-of-state or private college costs, and you would have to pay any difference.
2. Coverdell Education Savings Accounts
While not as popular as 529 accounts, distributions from Coverdell accounts are also free from federal taxes when used for eligible college expenses. In addition, distributions can be used to pay for designated K-12 education expenses.
Coverdell account contributions are limited to only $2,000 per year for families with a single income under $95,000 and joint incomes under $190,000. There is a reduced contribution limit for those with single incomes between $95,000 and $110,000, or $190,000 to $220,000 for joint filers. There are other tax implications that may make a Coverdell more complicated, so do some research if you’re considering this type of account.
3. UGMA/UTMA Custodial Accounts
One of the benefits of these types of accounts is that earnings will be taxed at your child’s rate rather than yours. There are no contribution limits, and there are no limits on how much income earn. The big disadvantage is how custodial accounts are treated when you apply for financial aid. Custodial accounts will be listed as your child’s assets, and this will lower the amount of financial aid your child might be eligible for. In addition, once your child is 18 or 21, depending on the state you’re in, the money in this account will be turned over to your child to manage.
4. Investment Accounts
With an investment account, you exercise full control of the money you contribute, along with the way it is invested. There are no income limits or contribution limits, and you decide when to withdraw the money and what to use it for. You will receive no tax breaks, however, and the money would be considered assets that can decrease the amount of financial aid your child could qualify for.
If you decide that saving for college is a priority for your family, the best time to start saving is when your child is a baby, or now, if you have not yet started. Research your options, decide on a savings goal, and begin today. This could also be the time to start teaching your children about financial literacy!