Saving for College Doesn’t Have to Be Hard — Here’s How!
If baby’s on the way, you’re likely gearing up for sleepless nights, planning nursery decor and learning how to change diapers like a boss. Saving for college is probably the furthest thing from your mind. However, with the cost of college and secondary education creeping up higher and higher each year, stashing cash away now can make a big difference to baby’s future.
According to College Board, the average cost of college tuition, housing and fees for the 2016-17 school year was $20,090—and that’s for in-state public college. The expenses jumped to $45,370 for a private school. Multiplied by four years, it adds up quickly to a range of $80,360 to $181,480 to get a degree. Ouch.
Oh, wait. Your baby’s not headed off to college for another 18 years, which means prices are only going to rise thanks to inflation. If the price tag on current college expenses frightened you, you might want to sit down for the reality of how much to save for college in the future. Because when your baby is ready to leave the nest, college expenses are expected to start at more than $215,000, according to SavingforCollege.com. Let’s face it: That’s no chump change.
Sure, you could cross your fingers and wish on shooting stars that your child becomes an academic prodigy or athletic idol worthy of full-ride college scholarships. Or you could settle back into reality and make a plan detailing the best way to save for college. Here are a few saving for college tips to get you started:
- Start early: Baby doesn’t need to be born for you to start saving for college. Even amounts as small as $25 a month at six percent interest can add up to nearly $10,000 in 18 years. While it may not be enough to pay the entire four years, every little bit helps to stave off debt. Plus, it’s important to remember that your income and expenses will change over the years, hopefully allowing you extra money to invest down the line.
- Cut costs: A baby can eat up a big portion of your monthly budget, but that doesn’t mean there isn’t room for additional savings. To stash extra cash in that college savings account, consider clipping coupons for grocery shopping, making more meals at home instead ordering take out and turning date nights into freebie nature hikes and picnics instead of dinner and a movie.
- Set goals: Sometimes working toward a specific amount can make the savings process more efficient. Set the college fund account based on your budget or use a college calculator to breakdown how much you would need to save each month to reach the college savings plan goal you want to achieve.
- Make it automatic: While the initial shock of a paycheck reduced by taxes and standard payroll deductions can be jarring, over time your lifestyle adapts to your income. The same may be true for your savings. Set up your savings for college to be automatically deducted from your account or employer paycheck (if available). The first check or two might sting a bit, but soon you may not even notice. You’ll save the money you need without it affecting your every day.
Once you’ve found the extra funds to set away for saving for college, what do you do with them? Traditional banks and credit unions offer saving accounts and money market tools, but they typically come with very low rate of return.
The best way to save for college is to invest your money using a tool with a higher interest rates, low fees and, if possible, tax incentives.
- 529 Plan: A 529 plan, also known as a “qualified tuition plan,” is federal tax-exempt college savings sponsored by individual states and various educational institutions. The funds in this college savings plan can be used toward qualifying expenses at post-secondary institutions.Your college choice is not affected by the state from which your 529 plan originates.
- Coverdell Education Savings Account (ESA): An ESA is similar to a 529 plan in that it’s a college savings account option with tax advantages. The funds may be used for educational expenses. However, unlike a 529 plan, the money is not limited to just college, but also can be used for preschool, prep school and private school.
- Roth IRA: Since IRA stands for “individual retirement account” you might think this tool snuck its way onto our college savings accounts list accidentally. However, while a Roth is typically a way to save for retirement, you have the option to withdraw funds tax- and penalty-free for the use of educational expenses after five years.
- Prepaid College Tuition Plans: Want to lock into lower college tuition rates now instead of paying the hiked up prices to come in 18 years? That’s where a prepaid college tuition plan comes in handy. If you make a contribution to the plan that equates to 50 percent of the annual tuition as it is today, for example, when it comes time for your tot to trot off to college, you’ll only pay 50 percent of the tuition at that time. That can mean bigger gains than other options, and many plans are still exempt from federal taxes. However, you’re usually locked into your home state’s universities and colleges.
While the Roth IRA and the prepaid college tuition plans are both viable options, they do have some downfalls. The Roth has low annual contribution amounts of a maximum $5,500 (for all Roth IRA accounts open), and the invested money could lower your future student’s potential for increased financial aid more significantly than a 529 plan or ESA. The prepaid college tuition plan can show a great rate of return, but most of the investments are not guaranteed by the state, and your child is typically locked into going to a state school. Given these reasons, the 529 Plan and the ESA are often the better choice when saving for college.
The differences between 529 and ESA plans are slim, but the variations in college savings plans may be just what helps you decide which is the best college fund for baby.
- Fund allocation: If you know your child will only need money for college, then the 529 plan may be the best fit. However, if you want your investment to be applicable to all kinds of education, including preschool, high school, college and post-secondary vocational schools, then your only choice is the ESA, as the 529 plan is only applicable to post-secondary education.
Contribution limits: The 529 plan comes with limited contribution restrictions. Contributions are viewed as gifts, and annually you are able to make a gift up to $14,000 per child without paying a gift tax. Additionally, a 529 plan has no income restrictions. On the flipside, an ESA only allows you to contribute up to $2,000 per year per child (including the money contributed by other family members) and the income phase-out is between $95,000 to $110,000 for single taxpayers and $190,000 to $220,000 for couples filing jointly, according to SavingforCollege.com.
Beneficiary: The 529 plan is pretty straight forward in that any person of any age—a family member, friend or yourself—can be a beneficiary on the account. With an ESA, a beneficiary must be under 18-years-old when the account is established.
Age limits: An ESA can only be started for a child younger than 18-years-old and must be used or rolled over to a qualifying member of the beneficiary’s family before the initial beneficiary turns age 30. Not doing so could result in tax penalties on the remaining amount. A 529 plan, with the exception of a few plans, does not have age restrictions in regards to signing up the beneficiary or use of funds. In fact, should a child not use the savings for college, the funds can be transferred to a grandchild or other beneficiary.
Account owner: The owner of a 529 plan has complete control of the investments, as well as how the money is used. The beneficiary cannot withdraw funds without the owner’s permission. For an ESA, once the beneficiary reaches 18 years of age, he or she has complete control of the account, making withdrawals at will, even if they lead to penalties for non-education expenses.
State income tax deductions: Many state 529 plans offer state income tax deductions, but none are offered with an ESA. Both types of plans can grow free of federal tax, however.
Transfer: If you have an ESA and are not happy with its performance, you can transfer the funds to a 529 plan with the same beneficiary. However, you cannot transfer an existing 529 plan to an ESA.
Want to know about the best of the best available plans for you when it comes to saving for college? There’s a lot of shopping around to be done, but we’re to help with our top picks for best college savings plans.
When it comes to an ESA, the Coverdell is the only type available and can be opened at most financial institutions, mutual fund companies or brokerage firms. Each location comes with its own fees, investment options and account features, so research what is available to you and choose the plan that best suits your needs.
The 529 plan requires a bit more comparison to find the college fund right for you. With many states and educational institutions vying for your business, there are a lot of options, all of which will be very competitive. A plan available through your home state is a good place to begin, as it may offer additional state tax incentives on your contributions. But remember, you are not limited only to your state’s plans, so exploring your options is a smart move.
Just like an ESA, a 529 plan comes with fees, investment options and restrictions that can help guide your choice in the right direction. Look at everything available to you before deciding. If you’re feeling overwhelmed, check out our top five 529 plans [link], each of which are strong performers, have low fees and allow for a variety of investment options.
Whether you decide to approach saving for college with a 529 plan or an ESA, your first step is always going to start with research. But once you have the fund type decided, it’s time to sign up.
You’ll need the name, address, social security number and date of birth of the beneficiary regardless of if you’re opening a 529 plan or an ESA. A 529 plan can be opened before baby is born. The account owner would list themselves as the beneficiary and then change the designated beneficiary once the necessary information on the baby is available. An ESA could be technically opened before baby is born as well, but the beneficiary named would need to be someone who is under the age of 18 and won’t turn 18 before the beneficiary is changed. If you really want to start investing early, the 529 plan is probably the better route to go.
Next, you’ll select the investment option right for you and your savings strategy. Since this may be foreign territory, consider enlisting the services of your financial institution, financial planner or your broker. And because both plans have tax implications, it may be beneficial to consult your accountant to discuss how to make the most of your money—and related tax relief—when saving for college.