For many parents, the thought of paying for their children’s college education can bring about feelings of pressure and anxiety. And with some schools costing more than $200,000 for a four-year degree, it’s certainly understandable. Whether or not you’ve already started a college education fund, here are some guidelines to get you through.
As with most financial goals, the sooner you start, the more likely you are to reach them. There are two main reasons for this. First, the more years you have to save, obviously, the less you’ll have to save each year. Second, and more importantly, for every year you put off setting money aside, you’ll forego years of investment earnings. For example, if your child is 15 years away from college, whatever money you set aside today will have the potential to sit in an account and earn interest during those 15 years. When you add up the effect of compounded interest, that’s a lot of money you won’t earn, even if you put it off just one year.
Read Related: Taking a Child to College Tests a Mom’s Strength
SET A GOAL
How can you point yourself in the right direction if you don’t know what your target is? Ask yourself: What type of college would you like to be able to provide for? Community college? A state university? Private or Ivy League? There are significant differences in costs. Do you want to be able to provide the entire cost of four years of college? What if it takes six years for your child to graduate? And are you willing to pay the entire cost each year, or only a portion of it? Based on your answers, you can now use a college cost calculator to calculate the amount you should be setting aside periodically.
CHOOSE YOUR PLAN
There are many different types of college savings vehicles, but not all of them may be a good fit. When choosing your plan, consider the available investment options, your risk tolerance, and the rate of return you need in order to meet your goal. Here are some popular options.
Section 529 Plans
Although they are very different, there are actually two types of Section 529 plans: Prepaid Tuition Plans and College Savings Plans. Both are named after Section 529 of the Internal Revenue Code, which specifies the requirements for the plans to be free from federal income taxes. Prepaid tuition plans allow you to let you lock in future tuition rates at in-state public colleges at current prices and are usually guaranteed by the state. College savings plans are more flexible, but do not offer a guarantee.
Prepaid Tuition Plans
Prepaid Tuition Plans tend to be more restrictive but protect you from both investment risk and the rapidly increasing costs of college. They do this by allowing you to purchase units (or years) of college at today’s prices which you can redeem in the future. For example, if you already had the money saved for all four years, you could pay for it now and not have to worry about any future price increases. Prepaid Tuition Plans are administered by each individual state and most can only be redeemed at that particular state’s eligible colleges and universities. Quite often there are also residency requirements. If the student decides to go an out-of-state college, or one that is otherwise ineligible, the pre-paid plan may pay an indexed (or average) tuition rate, leaving you to make up the cost difference.
College Savings Plans
College Savings Plans (also referred to as investment plans) allow you to set aside money in an account on behalf of your future student. Since you are setting aside money in an investment account which will be used to pay for college expenses at a later date, you not only bear the risk of the investments, but also the risk that your investments won’t outpace the increase in the cost of the tuition. On the other hand, you can set up the account with the financial institution of your choice and use the funds to pay for qualified expenses at any eligible college or university. Most plans offer various investment options that range in risk from low to high, and some may even offer a guaranteed rate of return.
Coverdell Education Savings Accounts (ESA)
A Coverdell Education Savings Account, formerly called the Education IRA, is a very simple way to save for your child’s education costs. Unlike some other types of accounts, this plan can be used to save for not only college expenses, but qualified elementary and secondary education expenses too. However, there are some restrictions. The maximum that can be set aside for the beneficiary is $2,000 per year. So if your goal requires you to save $300 monthly, you’ll need to utilize another strategy. In addition, when the account is established, the beneficiary must be under age 18. And you can only establish one if your adjusted gross income is less than $110,000 ($220,000 if filing a joint return). Contributions to a Coverdell ESA are not deductible, but any earnings grow tax-free. Additionally, if the amount withdrawn from the account is less than the student’s adjusted qualified education expenses for that year, the entire distribution will be tax-free.
UTMAs and UGMAs may be appropriate if you are only going to make a one-time contribution to a college savings fund. In reality, you can contribute any amount of money you want and decide where and how to invest it. But keep in mind that once your child reaches the age of majority in your state, the child is automatically given full ownership rights to the money and can do with it as he or she pleases. So if the child doesn’t go to college, or drops out at any point, the parent cannot recover the money. In addition, since the money is owned by the student, there may be some financial aid issues as well.
U.S. Government Savings Bonds
Series EE and I bonds were once a popular way to save for college. But given their now low rate of earnings, and the availability of other tax advantaged alternatives, savings bonds should be used only as a last resort.
If you are late in getting started or, for whatever reason, don’t anticipate achieving your college savings goal, don’t allow yourself to become discouraged. Your child may be able to make up the shortage by taking advantage of grants, scholarships, and loans.