How to Finance Your Child's College Education

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. Attending a four-year public college or university could easily exceed $100,000 in tuition and fee charges for out-of-state attendees. The price tag for four-year attendance at a private university has reached $240,000, for tuition only.

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 five simple steps for financing your child's college education.

1. Commit to Getting Started

The sooner you start investing in your child's education, the better. As with any other investment goal, time and compounding interest are 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 

An important step in making a college savings plan is to estimate what the total cost of your child's education is likely to be once they're ready to attend school. Using current tuition and fee figures can be helpful but they may not offer an accurate picture if they don't include things like inflation and rising tuition prices. Using a college cost calculator can help with forecasting future college expenses.

Once you've gotten a number in mind, the next step in planning is determining where the money to pay for college will come from. Your savings and savings contributions from grandparents or other family members are one part of the puzzle. But your child may also be able to get financial assistance through scholarships, financial aid, grants, and private student loans.

Consider carefully whether you plan to borrow student loans yourself to help finance your child's education. Taking out parent PLUS Loans or private loans means your child will have less debt to repay but accumulating student debt could put your ability to save for retirement or reach other financial goals at risk.

3. Save Consistently

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. 

For 2020, the annual gift tax exclusion amount is set at $15,000 for individuals or $30,000 for married couples. That means if you're married, you can gift up to $30,000 per child annually without incurring a tax penalty.

4. 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 account's 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, the distribution can be treated as taxable income. 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. 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.

Funds held in a 529 college savings plan can now be used to pay for private elementary, middle and high school tuition costs. The IRS allows you to withdraw up to $10,000 per year from a 529 for this purpose.

5. Invest Wisely

Saving money for college and investing it are two different things. Putting money into a savings account or money market account keeps it liquid but you won't see as much growth in interest as you would by investing in the stock market instead. In terms of investment vehicles, stock funds historically have almost always exceeded other investments over periods of ten years or more.

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 they 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 have left 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.

Look for no-load (no fee to purchase or sell) mutual funds or exchange-traded funds for diversification with fewer costs. Specifically, consider a fund's expense ratio, which reflects the annual cost of owning the fund expressed as a percentage of assets. The lower this ratio, the more of your investment earnings you get to keep.

Planning for college means taking a comprehensive approach to your finances but it's not impossible to do. If you start early, know your investment vehicle alternatives and invest wisely and regularly, you can position yourself to be able to pay for some or all of your child's college education without shortchanging your other financial goals.