Forbes - December 17, 2020
There are several ways to save for college, including 529 college savings plans, prepaid tuition plans and Coverdell education savings accounts. Of these, 529 plans are the best way to save for college.
Start saving for college when the child is young. Aim to save about one third of future college costs. Set up an automatic monthly transfer from your bank account to the 529 plan. Choose a direct-sold 529 plan with low fees, ideally one with a state income tax break on contributions. Use an age-based or enrollment-date asset allocation within the 529 plan to balance risk and return.
When to Start Saving for College
The key to saving for college is to save early and often.
Time is your greatest asset. Start saving for college as soon as possible. The sooner you start saving, the more time there'll be for your savings to grow and the earnings to compound. You can even start saving before the baby is born. To save before a baby is born, open a 529 plan account with yourself as the account owner and beneficiary, then change the beneficiary to the baby after it is born and has a Social Security Number (SSN) or Taxpayer Identification Number (TIN).
If you start saving at birth, about a third of the savings will come from the earnings. If you wait until the child enters high school to start saving, less than 10% of the savings will come from the earnings.
How Much to Save
Like any major life-cycle expense, college costs should be spread out over time. The one-third rule suggests a rough cut, with one third of the cost coming from past income (savings), one third from current income and one third from future income (loans).
There is a balance between savings and loans. If you want to reduce student loan debt at graduation, save more.
Since college costs increase by about a factor of three over any 17-year period (from birth to college enrollment), that suggests that the college savings goal should be the full cost of a college education the year the child was born.
For a child born this year, this translates into monthly savings of $250 per month for an in-state 4-year public college, $450 per month for an out-of-state 4-year public college and $550 per month for a 4-year private college. Saving $250 a month from birth will yield more than $80,000 by the time the child enrolls in college.
If you can't afford to save that much per month, save what you can. Every dollar you save is a dollar less you'll have to borrow. It is cheaper to save than to borrow.
Families should aim to save enough that the child's student loan debt at graduation will be less than their annual starting salary. If you keep student loan debt in sync with the student's income, the student should be able to repay their student loans in 10 years or less.
If you’ve already started saving and want to check if you are on-track to reach your college savings goals, multiply the child's age by $3,000 for an in-state 4-year public college, $5,000 for an out-of-state 4-year public college and $7,000 for a 4-year private college. If your college savings plan balance is at least this amount, you’re on track to save one third of the future college costs.
Make Saving Automatic
Set up an automatic transfer from your bank account to your 529 plan account. Many 529 college savings plans allow automatic contributions as low as $25 per month.
Making the saving automatic will make it easier to save, because you won't have to think to save. You'll quickly get used to having less money in your bank account.
It is easier to increase the amount you save after you get started. Consider increasing the amount you save whenever you get a salary increase at work. When your child no longer needs diapers or daycare, redirect this money toward your college savings plan contributions. Contribute all or part of bonuses, income tax refunds, and inheritances. Ask friends and family to give the gift of college instead of traditional holiday, birthday and graduation presents.
What Type of Savings Account Should You Use?
There are three types of specialized college savings accounts: 529 college savings plans, prepaid tuition plans and Coverdell education savings accounts. Of these accounts, 529 plans offer the best mix of tax and financial aid advantages.
Favorable tax treatment. Like a Roth IRA or Roth 401(k), contributions are made with after-tax dollars. Earnings accumulate on a tax-deferred basis and are entirely tax-free if used to pay for qualified higher education expenses. Unlike a Roth IRA, more than two-thirds of the states offer a state income tax deduction or tax credit based on contributions to the state’s 529 plan .
Favorable financial aid treatment. If a 529 plan is owned by a dependent student (a custodial 529 plan) or the dependent student’s parent, it is reported as a parent asset on the Free Application for Federal Student Aid (FAFSA) and distributions are ignored. Parent assets are assessed on a bracketed scale, with a top bracket of 5.64%. This yields a less severe impact on eligibility for need-based financial aid than student assets, which reduce aid eligibility by 20% of the asset value.
529 plans have generous contribution limits. 529 plans have special estate-planning benefits, such as superfunding (5-year gift-tax averaging). 529 plans do not have income restrictions. Almost all states offer at least one 529 college savings plan. Most states offer a direct-sold 529 plan and an advisor-sold 529 plan. Direct-sold 529 plans are offered directly by the state. Advisor-sold 529 plans are offered through financial advisors.
In addition to college costs, 529 plans can also be used to pay for up to $10,000 a year in K-12 tuition and up to $10,000 per borrower (lifetime limit) in student loan repayment.
Prepaid tuition plans let families buy a year’s tuition at a public college or university in the state and have it always worth a year’s tuition, giving you peace of mind. There are only about a dozen prepaid tuition plans that are still open to new investment. Many prepaid tuition plans have suffered from actuarial shortfalls, calling their tuition promises into question. There’s also a prepaid tuition plan offered by about 300 private colleges. Prepaid tuition plans can provide a hedge against tuition inflation.
Coverdell education savings accounts can be used to save for K-12 and college, but suffer from several limits. Annual contributions from all sources are limited to $2,000 per year. Contributions must stop when the beneficiary reaches age 18, and the account must be fully distributed by age 30.
Saving for college in a custodial bank or brokerage account , under the Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA), can have a negative impact on eligibility for need-based financial aid. UGMA and UTMA accounts are reported as student assets on the FAFSA, reducing aid eligibility by 20% of the asset value. These accounts also lack the superior tax treatment of 529 plans.
Series EE and Series I U.S. Savings Bonds offer tax-free interest when the bonds are used to pay for college or contributed to a 529 plan.
A Roth IRA has favorable tax treatment and allows a tax-free return of contributions. But, a tax-free return of contributions is reported as untaxed income on the FAFSA, which has the same impact on aid eligibility as taxable income. Contributions to a Roth IRA are also limited.
How to Invest
Saving and investing comes with risk. If you avoid all risk of investment loss, your savings will not keep up with inflation. But, if you choose investments with higher returns, they also come with higher risk.
Over any 17-year period, from birth to college enrollment, the stock market will experience at least three corrections and at least one bear market. A correction is a drop of at least 10% and a bear market is a drop of at least 20%.
Given that you can’t avoid all risk, the best solution is to manage the risk through the asset allocation. An asset allocation specifies the mix of stocks vs. low-risk investments.
An age-based or enrollment-date asset allocation, like a target-date fund, starts off with a high percentage invested in stocks (e.g., 80% to 100% invested in stocks) and gradually shifts the mix of investments to a lower percentage invested in stocks (e.g., 10% to 20%). This is a good way of balancing risk and return.
When the child is young, you will have less invested and more time to recover from any investment losses. When the child is older, you will have locked in your gains and a much smaller portion of your portfolio will be exposed to potential stock-market losses. More than two-thirds of families are invested in age-based asset allocations.
Investment options vary by 529 plan, but all 529 plans offer at least one age-based or enrollment-date asset allocation investment option. 529 plans also offer all-stock funds, fixed-income funds and money market accounts. Some 529 plans offer foreign stock funds and real estate funds, which tend to be riskier. Some 529 plans offer FDIC-insured CDs and savings accounts, which are a good option for risk-averse investors and for the low-risk portion of a 529 plan’s asset allocation.
How to Maximize Net Investment Returns
Minimizing fees is the key to maximizing net returns.
Choose a 529 plan that charges less than 1.0% in annual fees, often called the total expense ratio. Some 529 plans charge less than 0.5% in fees. Choose a direct-sold 529 plan, since they have lower fees than advisor-sold 529 plans, and don’t charge commissions. Consider both your state's own 529 plan, if your state offers a state income tax deduction or tax credit on contributions to your state's 529 plan, and a few out-of-state 529 plans with lower fees. Generally, lower fees matter more when the child is young and the state income tax break matters more after the child enters high school . The fees are charged on the full value of the 529 plan every year, while the state income tax break applies only to that year’s contributions. Passively-managed investment options, such as index funds, charge lower fees than actively-managed investments.
Choose a Cheaper College
Most colleges do not meet the student’s full financial need. The average unmet need (the gap between financial aid and financial need) is over $10,000 nationwide. So, most families will need to save or borrow or both.
Choosing a cheaper college will reduce the amount you need to save. While you can’t predict the specific college your child will attend, you can steer your child toward a lower-cost type of college. Public colleges, especially in-state public colleges, are less expensive than private colleges.
You can look up a college's net price using College Navigator . This tool will also show you how the net price has changed over time.
The net price is the discounted sticker price, which is the difference between the full cost of attendance (including tuition and fees, room and board, textbooks and transportation) and the gift aid (grants and scholarships). It is the amount you'll have to pay from savings, income and loans. The higher the net price, the more you'll need to save or borrow. By Mark Kantrowitz, Contributor
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