Updated: Aug 6, 2020
The college years are an exciting time of life. I remember the new feelings of freedom and independence. It’s a time when I think a lot of people feel that their lives are really finally starting because their choices are more their own without the boundaries their parents put in place during the earlier years. Many of us change so much intellectually, emotionally, relationally, and spiritually during those years. It is also a period of great risk in several ways, not the least of which is finances.
We all know that college is expensive. The average cost of one year of college is $30,000. Since the average household income is roughly $60,000 that price tag is hard to swallow for many people. If you’re a parent you want that experience to be a good one for your kids and not something they regret. So how do we tackle this?
We start by laying the groundwork for a solid financial future in our own lives. You need to get out of debt and build an emergency fund. These two things restore your control of your own income so that you can start working on longer term goals. Once you’ve achieved that you can start saving for retirement, paying off your home, and saving for your kids’ college. It’s very important that you don’t put off paying off the house and retirement in favor of saving up to send your kids to Harvard. If you do that, they’re going to end up in the position of having to figure out how to take care of YOU in retirement WHILE putting THEIR kids through college. I know you don’t want to do that. By taking care of yourself first, you’re also taking care of them later.
Once you have those other goals under way, you can start setting aside money for their education. How much? What I recommend doing is take a look at the different schools in your state and pick one with what seems like a reasonable price tag. You’re not committing them to a school, you’re just picking a baseline. Now that you have an idea of the cost you can work backwards to what you need to set aside each month. By the way, you don’t necessarily need to save up enough to pay the full amount. You decide what you want to contribute towards their college based on how much time you have to save, your income, and your other goals.
This is doable, folks. Investing just $85/month in good mutual funds over 18 years will yield around $50,000. Bumping that up to $166/month (the ESA maximum contribution) will create $100,000.
What kind of account are we going to use to do this? There are basically two good options. I’ll also mention two not-so-good options.
A 529 is an investment account funded with after-tax dollars that grows tax free as long as the money is used for higher education expenses. 529s are governed by federal rules AND state-specific rules. Each state has their own rules and structure for their 529s. You can open a 529 in most any state, not just the state you live in, but if you choose another state’s program the contributions probably won’t be deductible on your state income tax return. In many states, you are allowed to use the money for K-12 expenses as well. There is no annual contribution limit for 529s but most states put a cap on the account balance between $300,000 and $500,000, past which no more contributions can be made. There are two main downsides of 529s. One is that because they are state-specific there are 50 different programs. Some of them are good and some of them are not as good. You’d have to do significant research to find the best one or sit down with a financial advisor to get some guidance. The biggest downside to me is that in all of them you are limited in your investment options by the rules of the plan. Similar to 401k plans, 529s present the investor with a limited selection of mutual funds in which to put your money. Typically you can find better funds on your own (or with an advisor’s help) than the ones included in these plans.
The ESA, also known as the Coverdell ESA, is also an investment account that grows tax free as long as the money is used for education expenses upon withdrawal. Like the 529, ESAs can also now be used for K-12 expenses. These accounts are also funded with after-tax dollars. There are two main restrictions that distinguish ESAs from 529s. One is that you can not contribute more than $2k per year per child. The other is that the money must be used by the time the child is 30 years old. Also if you make more than $110,000/year ($220,000 if you're married, filing jointly) you can not open an ESA and you would need to go with the 529. The main benefit of the ESA is that, like an IRA, you’re in complete control of your investments. You can choose from the entire mutual fund market. This is a big advantage as you will usually be able to find investments that outperform the limited options in the state-sponsored plans.
It’s also important to note that, whichever account you choose, if you end up not needing all of the money for education expenses you will have the option to transfer the account balance to another beneficiary.
There are two types of accounts you may hear mentioned when discussing college planning that would not necessarily recommend. I want to talk about them a little bit just so you’re aware of them and explain why I won’t be using them.
UTMA stands for Uniform Transfer to Minors Act. This is an investment account that is not restricted to education costs. It does have some tax advantages but it is not fully tax-free growth like the 529 and ESA. It is between those and a regular brokerage account where you pay the full capital gains rate. The other major downside of the UTMA is that control of the account passes to the child when they become a legal adult. I REALLY like that the money can be used for anything, but the tax advantages are a little ho-hum, and I DON’T like that you have no control over the money when the kid turns 18. The fact that the money could be used for anything seems to me like too much responsibility and temptation for a teenager. This is the same reason our will requires our children’s inheritance to be managed by a trustee until they turn 25, and even then the trustee is empowered to judge whether they are ready for the responsibility. For this reason, we will likely not be using this option, but others may find it more appealing.
The Roth IRA is a retirement account. You contribute after-tax dollars which grow tax-free until retirement. If you withdraw the growth before you reach age 59-½ you will incur income taxes and additional penalties BUT the amount you contributed can be withdrawn at any time for any reason. At first glance, this might seem appealing because your college savings could potentially pad your retirement savings if your kid ends up getting scholarships or going the trade school route. However, because you can only withdraw your contributions you would not be able to take advantage of the power of compound interest (it’s not technically interest but it’s the same mathematical result). You would have to save the full amount. This could make it significantly harder to achieve your goals.
If you’re not sure which savings path is right for your situation, you don’t have to have that figured out to start saving. You can start small and put it in a savings account, which can be opened easily online within only a few minutes of finishing this blog post. Once you get the ball rolling, set a goal to get more information about these options. You can do that through your own research, or by booking a coaching session. Helping you to fit goals like saving for college into your overall financial strategy is exactly what financial coaching is all about.