How to Finance Your Child's College Education

Preparing for the Ever-Growing Price Tag of College Tuition

College graduate
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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 in a public college is expected to cost in excess of $100,000 and for a private school over $200,000. What is the average parent to do? The same way you should begin savings for your retirement in your twenties, 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.

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 for a public school now averages over $10,000 per 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 as much.

Don't let these numbers scare you into inaction. Some of your child's education can be paid for through scholarships, financial aid, and student loans.

It's possible to save the rest if you start early, contribute regularly, and invest wisely. Of course, you do not 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.

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 with low expenses. Refer to Money Magazine's semi-annual mutual fund listing that includes information on expenses and performance for thousands of funds or work with a certified financial planner (CFP).

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). But remember, if you take distributions beyond your original contribution amount from a Roth IRA before turning 59½, you will have to pay a hefty early withdrawal penalty, which will negate any tax benefit you received. You are also limited to the annual amount you can invest in a Roth IRA.
  • 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 on annual contributions and families with an adjusted gross income (AGI) above the limit cannot participate.
  • 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.
  • 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.

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