The 18-year clock starts ticking the moment your child is born.
That’s how Forbes financial writer Taylor Tepper addressed saving for college, and Kiplinger contributor Neale Godfrey took it a step further.
“The best advice is to start saving as early as possible,” she said. “Are you pregnant? Start now! Additionally, encourage your friends and family to help you along the way.”
Next to buying a home, a college education is the largest expenditure most parents will ever make. The key is advance planning. The more money you save now, the less money you or your child will need to borrow later.
It is important to begin saving as soon as you can so you can earn interest, dividends, and/or capital gains on as much money as possible.
In its annual survey of tuition costs, U.S. News and World Report found that the average cost of tuition and fees for the 2020–2021 school year was $41,411 at private colleges, $11,171 for state residents at public colleges, and $26,809 for out-of-state students at state schools.
Tuition, however, is not the only expense. The phrase “Cost of Attendance” represents the full price of a college before any aid, which NerdWallet calls the school’s “sticker price” and includes
- Tuition and fees.
- Books and supplies: Costs vary depending on the courses selected.
- Room and board: May vary depending on where the student lives (dorm, off-campus, home) and any meal plan chosen.
- Transportation: Varies depending on how far the student lives from the college.
- Personal expenses: Can include telephone bills, health insurance, late-night pizzas, personal spending money, or other variables.
Coastal Wealth Management, a North Carolina financial firm, estimated the average COA for the 2021-22 school year at $32,244 for public colleges and $64,098 for private schools. By 2025-26, those costs are expected to rise to $39,192 and $77,911, respectively.
[To help you plan, Charlotte State Bank & Trust offers a college savings calculator on its website.]
As a parent, if you’re not rich and you’d like to save your kids from incurring a huge debt burden, you need a plan. The good news is there are more options available to help than ever before.
529 College Savings Plans
These investment savings plans, operated by states or educational institutions, are tied to the stock market, similar to IRA or 401(k) plans. They provide several investment options for your account, allowing you to select the appropriate level of risk and potential return on your investment.
529 plans offer significant tax advantages, allowing any gains on the accounts to be tax-deferred. If the funds are used to pay for qualified education expenses, you will not need to pay taxes on those funds, and there is no federal tax on your account’s earnings.
CNBC reminds that 529 accounts are not guaranteed and will fluctuate, and the money must be used for educational purposes. Otherwise, upon withdrawal, earnings are subject to taxes and a 10-percent penalty.
There is some flexibility, however, in that you can use the account to pay for up to $10,000 per year in tuition for K-12 schools. You can also use $10,000 of your 529 plan for student loan payments.
In addition, you can change the account beneficiary to a family member, such as a sibling, niece or nephew, for their own qualified education expense use. You can even use the money to fund your own higher education aspirations.
Proceeds from a 529 can be used for tuition, books, fees, supplies, and room and board. Anyone can contribute to the account, but you control it, and your child will not have access to it.
Prepaid tuition plans
These investment savings plans offer the same tax advantages as 529s, but may not be offered in all states and may be restricted to in-state public schools. A big difference is that while 529 plans fluctuate with the stock market, states may assume the market risk of prepaid plans.
Keep in mind that if your child decides to attend an out-of-state college, you may not get the full value of your plan returned. You can, as with 529s, change beneficiaries, but the money can only be used for tuition. Funds used for other expenses incur a 10-percent penalty.
Florida’s prepaid plan covers tuition, local fees and, optionally, dormitory housing. When your student is ready for college, the plan pays the costs covered under your plan type at any Florida college or state university, even if the cost of college is higher than anticipated when your plan prices were set.
Moreover, the Florida plan pays the same amount if your child attends an out-of-state college or private college. Also, your student has 10 years from their projected college enrollment date to use the plan.
(For more on Florida’s 529 and prepaid tuition plans, including a breakdown of monthly costs and enrollment information, visit Florida Prepaid, a MyFlorida.com resource page.)
Coverdell Education Savings Accounts (ESAs)
The Coverdell ESA, named for the late Georgia Sen. Paul Coverdell, who sponsored the legislation that instituted the plan, is another tax-free method of saving for college. A major difference is that in addition to college expenses, ESAs can be withdrawn tax-free to pay for a broad range of K-12 expenses, while 529 plans are limited to K-12 tuition.
You may invest up to $2,000 annually on an after-tax basis per child in an ESA. Earnings accumulate tax-free, and money withdrawn to pay for qualified education expenses (tuition, fees, books, equipment, room and board) is free from income taxes. Withdrawals may be made for qualified expenses related to education from kindergarten through grade 12 and for undergraduate and graduate education.
Contributions must stop when a child reaches age 18. Funds not used for education by the time the child reaches age 30 must be transferred to a younger beneficiary or must be withdrawn, and these funds will be subject to tax on the earnings and a 10 percent penalty. Also, funds can be transferred from Coverdell ESAs to 529 plans.
Also known by the acronyms UGMA (Uniform Gifts to Minors Act) and UTMA (Uniform Transfers to Minors Act), these are special accounts set up by parents and grandparents for the exclusive benefit of their children and grandchildren. While custodial accounts don’t offer tax-free growth and distributions like 529s and Coverdell ESAs, they do offer another tax benefit: Most of the earnings are taxed at the child’s rate, which is usually lower than the parents’ or grandparents’ rates.
There are no annual contribution limits, although contributions above $14,000 a year (or $28,000 if married filing jointly) may be subject to federal gift taxes. There are no restrictions on how the funds are used as long as they directly benefit the child.
And unlike the other college savings accounts, you will not have the ability to transfer the account to another child or change beneficiaries when your child is eligible to receive the money.
Roth Individual Retirement Accounts (IRAs)
IRAs are usually thought of as retirement savings tools, but many families use them as potential college savings vehicles as well. Contributions to Roth IRAs can be withdrawn prior to age 59 1/2 for any purpose you choose without tax or penalty. This includes paying for private school, college or any other form of higher education.
With this strategy, you could withdraw some or all of your Roth IRA principal for college and leave the earnings in the account for retirement. With a Roth IRA, you receive no deduction for contributions, but all earnings are tax-free upon withdrawal.
Another option is opening a trust in your child’s name.
When should you start saving for college?
As mentioned at the beginning of this blog, the earlier the better. But even if you haven’t started saving, and your child is nearing high school or later, there’s still value in opening an account. Choosing an account with tax benefits will place you in a better position than not saving at all.
“Don’t use all your retirement money to help pay for your child’s college,” Godfrey cautioned. “Remember, they are young and can borrow or apply for financial aid; you cannot borrow or get a scholarship for retirement.”
Tepper and Godfrey agree on the importance of saving early and on a regular basis. And you should let you child in on the process. Remember, you’re saving for their future.