As life starts settling back to a normal routine following the arrival of your child, your attention will turn to the daunting prospect of funding their education. Beyond the basic need to stash away dollars, there is a myriad of choices today for educational savings. Plus, keeping your retirement savings on track will avoid requiring your son or daughter to support you in your golden years.
Saving for College
According to a College Board report(1), the average cost to attend a private four-year college will be around $45,000 for the 2016-2017 school year. Assuming a 5% inflation rate on college expenses implies a cost in 18 years of over $100,000/year or $400,000+ over 4 years. In-state public schools are about half as expensive.
Fortunately, as college costs have continued to increase, so has the availability of grants and scholarships to help lighten the load. As with saving for any goal, the earlier you start the better. The power of compounding returns works wonders—$10,000 earning an 8% return over 18 years turns into $40,000. Before you start socking away money, select the correct account type to facilitate your savings. Analyzing all the options for education savings can quickly get complex.
I will hit on a few of the more common approaches.
Use a tax-advantaged education savings account – There are several different types of accounts allowing tax-free earnings if the money is used for education expenses. For example, if you contribute $10,000 today and over the next 18 years the investments grow to $40,000, you can spend the entire $40,000 on educational expenses without owing taxes on the $30,000 in gains.
Depending on your state and tax situation, the savings could potentially be over $10,000. Probably the two most common options are 529 Plans and Coverdell Education Savings Accounts (ESA).
Although these accounts both allow tax-free withdrawals, they have a few differences. ESAs allow you to invest in almost any security, much like a normal brokerage account. Contributions are capped at $2,000 per year with lower limits based on income.
Although 529 Plans allow larger contributions, investment options are usually limited. Since plans are sponsored by individual states, each state’s plan is a little different. You don’t need to use your home state’s plan, nor does your child need to attend college in the state you have the 529 Plan. Program fees charged to administer 529 Plans are generally in addition to fees for similar investments in an ESA.
Open a custodial account in your child’s name – By opening an account in your child’s name, you can reap many of the tax savings (due to child’s low tax bracket) without the restrictions. There are no contribution restrictions (beyond regular gift tax limits), and the money does not need to be spent on education.
The downside is loss of control by the parent. Once you have funded a custodial account, the money must be spent for the child’s benefit and the money becomes theirs—to do with as they please—once they reach the age of majority.
Of course, you can also save for college using a standard, taxable account. Clearly, this is the simplest option. The disadvantage is that you are giving up potential tax advantages. The impact depends on your individual situation and how you invest the money outside a tax-sheltered account.
Saving for Retirement
Although funding your kid’s education may seem like a more pressing need than saving for your own retirement, your family will be well served by ensuring that your retirement is on track before committing dollars for college.
This may seem counter-intuitive, given college expenses are “only” 18 years (or less) away, whereas you don’t plan on retiring for perhaps another 30 years. But putting retirement savings first is simply a matter of alternatives. There is no alternative for funding your retirement. No one is going to loan you money, give you a grant or award you a scholarship to fund your retirement. If your savings fall short, you will either need to get by on less, or continue working past your desired retirement age (if you are able to).
Conversely, there are many ways to pay for college. Beyond attending a lower-cost school to reduce the burden, there are Federal loan programs, grants, part-time jobs, and scholarships to help provide funding. Although you clearly want to avoid saddling your child with debt, it may be better than sacrificing your own retirement aspirations and perhaps saddling them with the cost of your care when your savings run out in retirement.
1 College Board’s Trends in College Pricing 2016
Share Your Thoughts