Saving for college is a major challenge, requiring discipline and a realistic view of the future. While it may not be easy, there are many things that families can do—such as starting early—that can help make it less daunting.
No matter how old your child is, there are a few key principles to saving for college. The first is to find the money to invest in a college fund. The second is to consider the tax, control and aid tradeoffs of different financial account structures. Finally, you should consider the costs of college as part of the total college preparation and application process.
Sources of college savings
All savings projects start with finding the money to set aside. Raising children is expensive, but it varies from year to year. Not every developmental stage costs the same. You can put those differences to work. For example, when your child outgrows diapers, start putting the money you’re now saving into a college account. Likewise, money that went to daycare can be used to for the college fund when the child reaches school age.
In many families, aunts, uncles and grandparents give children cash gifts for birthdays and holidays. This money can be added to a college fund, too. If your family doesn’t have this tradition, you can encourage it when someone asks for gift suggestions. Most kids won’t miss another toy—but most 18-year-olds will appreciate and remember a gesture that shows someone cared enough about their future to help them prepare for it financially.
College savings should be a line item in the family budget, although beleaguered budgeters will tell you it is only one financial goal among many. If you are not saving for retirement, address that before setting up college funds. Retirement assets do not count toward family assets when a college makes its financial aid decisions, which is another reason to make retirement a priority before you invest in college.
Basics of college accounts
One of the most popular ways to save money for college is the 529 plan, named for the segment of the tax code that created it. These are offered by state governments or educational institutions. The contributions are not tax deductible, but the investment earnings are not taxed. Some states offer additional tax benefits.
The money in a 529 plan is controlled by the donor, usually a parent, who is responsible for using the money to cover bona fide higher education expenses. Any money not used by the named beneficiary can be transferred to another beneficiary in the same family. (A Coverdell Education Savings Account is similar to a 529 plan, but it can be used to cover elementary and high school expenses, too.)
Readers of SavingForCollege.com, a website that covers higher education financial issues, overwhelmingly favor 529 plans, which allow college contributions to accumulate funds free of tax. "College savers seem to understand they face a major challenge, and they're being savvy in how they approach it—looking for options both to save more and keep costs down," Martha Kortiak Mert, vice president of marketing at SavingForCollege.com, said about the survey.
Historically, the biggest drawback to 529 plans has been the high fees charged by some state plans, but Kortiak Mert notes these have been coming down over time. The company reports that administrative fees for 529 plans range from 0.10% to 0.70%, and that it expects future reductions.
Some 529 plans are set up as pre-paid plans, good for a specific university or within one state. These may offer a greater return, but they have one big drawback: the beneficiary may have other plans, may not want to go to the college in question or go to college at all. In these situations, the money can be converted to a general 529, though usually with a penalty.
Given the different types of plans and the different fees on them, it pays to shop around for a 529 plan. Many parents have been surprised to find the best 529 for their family is offered by a state clear across the country.
If parents want total control over the money, they can keep the funds in regular, taxable, investment accounts. The taxes are the price of greater flexibility over the funds. Some mutual funds and exchange-traded funds (ETFs) are managed to reduce tax obligations for long-term investors, something to consider if you go this route.
Some families bet that if they don’t save any money, they will end up with more financial aid. This is risky, and college financial aid offices are savvy to the tricks. The Free Application for Federal Student Aid, or FAFSA, considers a 529 plan funded by the parents to be a parental asset, and 5.64% of parental assets (except retirement accounts) are considered to be available for college tuition. Meanwhile, 20% of assets held in the student’s name will be counted toward the family contribution.
Roth IRA contributions may be withdrawn to pay for college without incurring a tax penalty, so some families opt for that to maintain both flexibility and the advantages of tax-free investment returns. However, the amount that is withdrawn will be counted as income. The increased income reported on the FAFSA may reduce any aid offered by the campus.
In general, if your family income is high enough that you could have reasonably saved for college, don’t expect the college aid office to reward your bad behavior. Keep in mind that many colleges offering aid do it in the form of loans, so saving money today will reduce the bill that comes due after graduation. To a financial aid officer, there is a big difference between a family that can’t afford college and a family that it is reluctant to cover the costs.
Money and college planning
SavingForCollege.com’s reader survey found that almost 49% of parents want to pay for a large portion of their child's college expenses, but only 32% are confident they will be able to cover the costs of their child's preferred school. This shouldn’t be a surprise because there’s so much uncertainty about what a family’s financial position will be, how college costs will change over time and where college fits into a child’s future.
As your child approaches college age, there are a few discussions related to financial planning that your family should have. First, not every child is ready for college, at least not at age 18. Many high school graduates are now taking gap years in order to find new focus on their education goals and to develop life experience, a way to improve their chances of success when they step on campus.
There are also ways students can help fund their own educations, such as joining the military or enrolling in a co-op study program. Some colleges will accept credit from Advanced Placement, International Baccalaureate or community college classes, helping your child save money on tuition through hard work in high school. However, not all colleges accept these credits, so make sure to check with your child’s college of choice.
The key is making your student a partner in the process. Your child needs to understand the costs of the different choices, the amount of money the family can reasonably spend, and the effect of student loans on his or her career decisions. The reality is that there are a lot of ways to get a good education, and the admissions process will be less stressful if both parents and students are open to a range of possibilities.
Frank Bruni, a columnist for the New York Times and author of “Where You Go Is Not Who You'll Be: An Antidote to the College Admissions Mania,” has done extensive research on the benefits of education. He makes the point that the academic challenges faced in college, the hard work that goes into passing classes and the exposure to new people and ideas matter far more than the name of the institution attended.
Don’t lose sight of the big picture. College is an investment, but not just an investment of money. It requires discipline, hard work, and critical thinking. Saving for college is important, but it is just one of many ways parents prepare their children for life.