How To Finance Your Child's College Education

College graduate in blue cap and gown smiling at parent
•••

Fuse / Getty Images

You've probably heard the depressing estimates of the cost of a college education if you're the parent of a newborn or a young child. What seems prohibitive now will be even worse when your child is ready to enter college in about 18 years.

Attending a four-year public college or university can easily exceed $100,000 in tuition and fee charges for out-of-state attendees. The price tag for four-year attendance beginning in the 2021-2022 school year at a private university reached $240,000, and that's for tuition and fees only, according to U.S. News & World Report.

So what's the average parent to do? You should begin saving for your child's tuition sooner rather than later, just as you should begin saving for your retirement in your twenties if financing their higher education is one of your goals. Here are five simple steps you can take to do that.

1. Commit to Getting Started

The sooner you start investing in your child's education, the better. Time and compounding interests are your best friend and most valuable asset, as with any other investment goal. The earlier you begin saving regularly, the less you'll need to save in the long run. 

Take a look at your budget to determine how much you can devote to college savings. Even if it's just $50 per month, that's a start. And you can boost your savings rate as your income grows or expenses decrease. Reach out to the grandparents to find out if they might be interested in giving your child's college education fund a jump start if you personally can't afford to save anything just yet.

2. Have a Plan 

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

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, and 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 that your child will have less debt to repay, but accumulating student debt could put your ability to save for retirement at risk.

3. Save Consistently

You not only need to start saving early, but you must also invest aggressively and regularly in order to amass enough money to finance four years of college. Consider contributing a small amount each month rather than investing a certain lump sum every year. This will let you take advantage of the dollar-cost averaging strategy and compound interest because every month counts.

An alternative strategy is to front-load your child's account if you're saving in a 529 plan. 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, however.

The annual gift tax exclusion amount is set at $15,000 for individuals or $30,000 for married couples in 2021. This increases to $16,000 and $32,000 respectively in 2022. You can gift up to $32,000 per child in 2022 without incurring a tax penalty if you're married because you and your spouse each get that $16,000 exclusion.

4. Know Your Savings and Investment Options

A combination of investment vehicles and financing methods will probably work best when trying to come up with the money for your child's college education. 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:

A Roth IRA

A Roth IRA may be an attractive investment vehicle if you'll be at least 59½ when your child heads off to college. The investments will grow tax-free, and withdrawals will also be tax-free if you've had the account for at least five years. You can withdraw your contributions at any time, and you can withdraw earnings before age 59½ without paying the 10% early withdrawal additional tax as long as you use the money for qualified education expenses.

Coverdell Education Savings Account

While contributions to a Coverdell ESA (formerly known as an Education IRA) aren't tax-deductible, the account's value will grow tax-free, and distributions from the account are tax-free when they're used for qualified education expenses for the designated beneficiary. But you must pay taxes on the money you contribute now. There's no tax deduction for Coverdell contributions.

The primary downside to Coverdell ESAs is that there's a relatively low limit of $2,000 on annual contributions, and families with adjusted gross incomes (AGIs) above the limit can't participate. You can't make any new contributions to the plan once your child turns 18.

All Coverdell ESA savings have to be used before your child turns 30. You'll pay a stiff tax penalty on any remaining balance otherwise.

A 529 Plan

State college savings plans, commonly referred to as 529 plans, allow you to earn stock market returns on college savings that you won't need for several years. Contributions grow tax-free, and distributions used for qualified higher education expenses are not taxable.

Another benefit is that contributions may be deductible from state income tax, but there can be restrictions or requirements, such as eligibility might be restricted to those who invest in a 529 plan sponsored by their state of residence.

However, distributions can be treated as taxable income if the money isn't used for qualified education expenses. You want to be careful not to over-save into a 529 Plan. There's no annual contribution limit, but these plans do have lifetime contribution limits in most states. The limit varies by plan.

Prepaid Tuition Plans

These plans are another type of 529 plan, but unlike 529 education savings plans, the state takes on much of the risk. 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, and they can only be used at in-state public universities. Using the money for any other purpose or other college will result in penalties.

Prepaid tuition plans also limit your growth to the rate of public college tuition increases in your state.

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

5. Invest Wisely

Saving money for college and investing those funds 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 if you invested in the stock market instead. Stock funds historically have almost always exceeded other investments over periods of 10 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 necessary adjustments for any 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 they can also manage and monitor investment performance and send you quarterly statements.

Be sure to account for the time you have left to invest if you're managing your own investments. It might be time to begin to shift your money into growth and income stock funds and bond funds if your child is five years from starting college. This will reduce your exposure to market ups and downs while still aiming for high returns.

Cash in enough stocks and bonds to pay for the first year two to four years before your child is due to start college. Put it somewhere safe and accessible, like a money market fund. You may be forced to take it out at a time when market performance is down if you wait until just before you need the money, thus losing some of your earnings.

Look for no-load mutual funds or exchange-traded funds for diversification with fewer costs. They have no fee to purchase or sell. Consider a fund's expense ratio, which is 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. 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 if you start early, know your investment vehicle alternatives, and invest wisely and regularly.

Article Sources

  1. U.S. News & World Report. "10 Most, Least Expensive Private Colleges."

  2. Internal Revenue Service. "2021 Instructions for Form 709: United States Gift (and Generation-Skipping Transfer) Tax Return," Pages 6-7.

  3. Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2022.”

  4. Internal Revenue Service. "Publication 590-B, Distributions From Individual Retirement Arrangements (IRAs)," Pages 24-26.

  5. Internal Revenue Service. "Topic No. 310 Coverdell Education Savings Accounts."

  6. U.S. Securities and Exchange Commission. "An Introduction to 529 Plans."

  7. Internal Revenue Service. "Qualified Tuition Plans."

  8. U.S. Securities and Exchange Commission. "An Introduction to 529 Plans."