How to Finance Your Child's College Education
If you're the parent of a newborn or young child, you've probably heard the depressing estimates of the cost of a college education when your child is ready to enter college about eighteen years from now. The cost of four years of a public college is expected to cost in excess of $100,000 and for a private school over $200,000.
So what's the average parent to do? The same way you should begin saving for your retirement in your 20s, you should begin saving for your child's tuition sooner rather than later if financing their higher education is one of your financial goals. Here are 5 simple steps to getting started on financing your child's college education.
1. Start Now!
The sooner you start investing for your child's education, the better. As with any other investment goal, time and compounding interest is your best friend and most valuable asset. The earlier you start regularly saving, the less you will need to save in the long-run.
Take a look at your budget to determine how much you could devote to college savings. Even if it's just $50 per month, that's a start and as your income grows or expenses decrease, you could boost your savings rate. And if you can't afford to save anything just yet, reach out to the grandparents to see if they might be interested in giving your child's college education fund a jump start.
2. Have a Plan
The first step in making a college savings plan is to estimate what the total cost of your child's education is likely to be. The average in-state tuition and fee total for a four-year public school came to just under $10,000 for the 2017-18 academic year. At five percent inflation per year, the estimated cost per year 18 years from now would be around $24,000 (10 years from now the cost would be approximately $16,000). Private schools can be two to three times more expensive.
Don't let these numbers scare you into inaction. Some of your child's education can be paid for through scholarships, financial aid, grants and private student loans. Even if you're short of your goal now, it's possible to save the rest if you start early, contribute regularly, and invest wisely. Of course, you don't have to plan for 100% of your child's tuition if that's not your goal. To get started on a plan, you can check out free online tools like SavingforCollege.com's college savings calculator.
3. Save Often and Regularly
In order to amass enough money to finance four years of college, you not only need to start saving early but also invest aggressively and regularly. Rather than investing a certain lump sum every year, consider contributing a small amount every month to take advantage of dollar cost averaging strategy and compound interest, as every month counts.
An alternative strategy is to front-load your child's account if you're saving in a 529 plan. (More on those below.) Front-loading allows you to make up to five years' worth of contributions to a college savings account on behalf of your child. The total amount of those contributions can't exceed the annual gift tax exclusion for that five-year period.
4. Invest Wisely
The only thing worse than not saving at all is putting your money in a passbook savings or money market account. In terms of investment vehicles, stock funds historically have almost always exceeded other investments over periods of ten years or more. Look for no-load (no fee to purchase or sell) mutual funds or exchange-traded funds for diversification with fewer costs.
But, don't just park your money in a fund or two and leave it. Review the performance of the funds at least annually, and make adjustments as necessary for under-performing funds. One of the benefits of working with a financial planner is that he or she not only provide advice on your savings plan, but can also manage and monitor investment performance and send quarterly statements. If you are managing your own investments, be sure to account for the time you left have to invest. For instance, if your child is five years from starting college, it might be time to begin to shift your money into growth and income stock funds and bond funds, reducing your exposure to market ups and downs while still aiming for high returns.
Two to four years before your child is due to start college, cash in enough stocks and bonds to pay for the first year, and put it somewhere safe and accessible, like a money market fund. If you wait until just before you need the money, you may be forced to take it out at a time when market performance is down, thus losing some of your earnings.
5. Know Your Savings and Investment Options
When trying to come up with the money for your child's college education, a combination of investment vehicles and financing methods will probably work best. Be sure to take advantage of any tax-deductible or tax-deferred methods that you're eligible for. Some of the best investment options for college savings include:
- Roth IRA: If you'll be 59½ when your child is in college, a Roth IRA may be an attractive investment vehicle, because the investments will grow tax-free and withdrawals will also be tax-free (assuming you've had the account for at least five years). You can withdraw up to $10,000 tax- and penalty-free before age 59 1/2, as long as the money is used for qualified education expenses.
- Coverdell Education Savings Account (formerly known as an Education IRA): While contributions to a Coverdell ESA are not tax-deductible (meaning you must pay taxes on the money now), the accounts value will grow tax-free and distributions from the account are tax-free when used for qualified education expenses for the designated beneficiary. The primary downside to Coverdell ESAs is that there is a low limit of $2,000 on annual contributions and families with an adjusted gross income (AGI) above the limit cannot participate. Once your child turns 18, you can't make any new contributions to the plan. All Coverdell ESA savings have to be used before your child turns 30; otherwise, you'll pay a stiff tax penalty on any remaining balance.
- State College Savings Plans (529 Plans): 529 plans give you the opportunity to earn stock-market returns on college savings you don't need for several years. Contributions grow tax-deferred until the money is used to pay for college, then earnings are taxed at the student's tax rate, another attractive benefit as the student's tax rate is generally lower than their parent's. If the money isn't used for qualified education expenses, however, there can be a penalty of 10% to 15% of your accumulated earnings or 1% of the account balance.So you want to be sure not to over-save into a 529 Plan. For most state's 529 plans, there is essentially no annual contribution limit but these plans do have a lifetime contribution limit. The limit varies by plan.
- Pre-Paid Tuition Plans: These plans are essentially another type of 529 plan, but unlike 529 plans, the state takes on much of the risk in the pre-paid plan. These state-run plans are particularly attractive as college tuition rates are rising around 10% a year. But they come with some major limitations. First is that the invested funds can only be used for tuition and fees (not room and board or other expenses) at in-state public universities. Using the money for any other purpose or college will result in paying penalties. Second, pre-paid tuition plans limit your growth to the rate of public college tuition increases in your state. So when tuition increases level off at 4 to 5%, these plans are no longer very attractive vehicles for financing a college education.
If you start early, know your investment vehicle alternatives, develop a plan, and invest wisely and regularly, it is possible to pay for some or all of your child's college education.