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9.7.2022 / Financial Tips

How to Start Saving for College

College is an expensive investment that requires planning years before your child becomes a college student. In the United States, the average college student loan debt is $37,014 while the overall student loan debt is $1.72 trillion according to Education Data Initiative. To avoid saddling yourself or your child with hefty debts, start saving now.

The best way to start saving is to choose a savings plan. With so many plans to choose from, weighing the options can be overwhelming. To help you navigate this decision, we have listed the best savings plans options with the pros and cons of each so you can figure out the right fit for you and your family.

  1. 529 Account The 529 savings account is designed specifically to fund education and is by far the most popular because of the flexibility and benefits. With 529 accounts, the money you invest receives federal and state tax benefits, and all withdrawals from the account are completely tax free. There is a limit on the amount of money you can put in the account, but the limit is very high. You can invest over $16,000 annually into the account, and the maximum investment can exceed $500,000. Friends and family can also contribute and receive a tax benefit. You’ll want to remember that your earnings will be subject to income tax, and you can be fined a 10% penalty if the funds are used for non-educational purpose. However, the benefits far outweigh this downside. For example, 529 accounts are reported as parent assets on FAFSA and thus, yield less severe impact on eligibility. Also, two-thirds of states offer a state income tax deduction or tax credit based on 529 plans. There are no income restrictions, and 529 plans can be used to pay up for $10,000 a year in K-12 tuition and up to $10,000 per borrower in student loan repayment. If you are saving money specifically for education, the 529 plan is your best option. To learn more, check out your state’s 529 plan here.

  2. Prepaid Tuition Plans Prepaid tuition plans are a type of a 529 account that grants you peace of mind knowing your student’s college tuition is covered. Some state schools have prepaid tuition plans for in-state universities, which allows you to purchase a set number of credit hours at the university’s current pricing for the future student. Unfortunately, only nine U.S. states (Florida, Maryland, Mississippi, Massachusetts, Michigan, Nevada, Texas, Pennsylvania, and Washington) currently offer this plan. Prepaid tuition plan dollars can only go toward tuition. So, this means that any other housing costs and additional academic costs (i.e., textbooks, laptop, etc.) are not allowable expenses.

  3. Coverdell Education Savings Account This type of savings account is specifically designed to fund education. To qualify for this savings plan, you must be a married couple earning less than $220,000 or individuals earning less than $110,000. If you do qualify, a benefit of this particular savings account is that you can use the money for K-12 expenses (tutors, uniforms, etc.). Coverdell also allows you tax-free interest earnings and withdrawals. But there a few limits. Yearly contributions cannot exceed $2000, and contributions must stop completely when the beneficiary turns 18. Coverdell savings must also be used completely before the beneficiary turns 30, or alternatively turned over to a different beneficiary.

  4. Roth IRA Account Roth IRA accounts are funded by after-tax dollars, so the earnings are completely tax-free. This savings account is ordinarily used for retirement, but you can withdraw funds for non-retirement purposes. It is important to note that only contributions can be withdrawn for non-retirement expenses, but not your earnings. Other family members cannot contribute to the account and since Roth IRA accounts are considered untaxed income, this does reduce your eligibility for financial aid on the FAFSA (Free Application for Federal Student Aid) application. Should your child decide not to use the money you saved for education, the benefit of this saving plan is that you still have money saved for retirement.

  5. Custodial Accounts— UGMA & UTMA Another option to save money for college is UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfers to Minors Act) accounts, or custodial accounts opened by an adult on a child’s behalf. These allow adults to gift money to minors without giving them full control over the funds until they turn the age of majority (usually 18-21 years old). The money you put in the account is diversely invested and there is no limit on your contributions. However, the earnings from the account are subject to the “kiddie tax”. A few things should be kept in mind on custodial accounts. The value of the account is removed from the donor’s gross estate, but it is considered a student asset on FAFSA applications. This means that the financial aid package the student may be eligible for could be drastically reduced. Another factor is that money kept in custodial accounts can be used for any purpose by beneficiaries—including non-educational purposes. Have a discussion with your child about the core purpose of the account and implement a few “honor” rules before setting up a fund.

  6. Qualified US Savings Bonds This is by far the safest investment option. U.S. savings bonds are federally tax-deferred and state-tax free. If used for higher education expenses, the bonds are federally-tax free. Furthermore, the bonds are backed by the full faith of the United States government. The downside is the maximum investment is $10,000 ($20,000 if married and filing jointly). Furthermore, because it is such a safe investment option, the returns you receive are significantly smaller than other investment opportunities. The money should only be used for tuition and fees, otherwise the interest earned will be treated as federal income and taxed.

  7. Mutual Funds These are diversified funds that are managed by a financial advisor. A benefit of this option is there are no limits on how much you can invest or what you spend the money on. However, the money is subject to annual income taxes and may be subject to the “kiddie tax” as well. Like most of the other fund options, the money is considered income and will impact financial aid eligibility.

  8. But how much should you save? Best case scenario is to start investing when your child is born as savings with be nearly three times larger due to compounded interest received over a longer period of time. The general rule of thumb is to save enough for one year of college tuition at the price the year the child was born. This typically follows the one-third rule. Meaning, college should be financed one-third by savings, one-third by your current income, and one-third supplemented by loans, financial aid, or scholarships. How much you save also depends on what kind of college your child plans to attend. According to Forbes, if you plan to attend a four-year in-state public college, you need to save $300 a month. For a four year out of state college, save $450 a month and save $550 a month for a private four-year college. It is important for a child’s student loan debt at graduation to be less than their annual starting salary. This way, they can pay off their loans in less than 10 years. Many parents require their children to also financially contribute to their college expenses. Valuable lessons in financial planning and savings can be taught when children take a portion of their summer job to contribute to the college fund. Students can also qualify for work-study positions at their university or become a Dorm Resident Assistance (RA). Depending on the university, RA’s can qualify for free or reduced room and board and even make from $3,000 to $10,000.

College is an expensive endeavor. To make it fiscally manageable, start saving early and make a gameplan now. Set up automatic transfers to your investment account so you are not tempted to spend the money while it is easily accessible in a checking account. Pick and option that best fits you and your family’s needs. Regardless of what plan you choose, the earlier you start saving—the better. A dollar you save now is a dollar you won’t have to borrow later.

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