It is graduation season – quite an exciting time for many families – and depending on how you planned to pay for school it could be a relief or a financial burden. I just read an article where a couple accumulated around $500,000 in debt to pay for their children’s college education – that’s cray-cray! I also hear a lot of co-workers talking about how much their kid’s college tuition cost and how they are broke because of it.
I understand we want the best for our children, but going into debt for them might not be the smartest move. There are plenty of ways our children can obtain a college education without having to put a dent in our savings – we just have to plan ahead.
According to a recent study conducted by Sallie Mae and Ipsos – How America Saves for College – only about 50% of families with children under the age of 18 are saving for college. The study also shows that out of those who are saving, about 75% are not utilizing the best options when saving for college.
Before we jump into the different options available and before we set aside a single penny towards our children education, we first need to have our finances in order. We need to make sure we have a fully funded emergency fund in place and we have to make sure we are saving at least 15% of our income towards our retirement. There are plenty of ways that can help our children pay for school – student loans, scholarships, work-study, etc. – but there is nobody to help us pay for our retirement. So before you start investing financially in your children’s education, make sure you take care of yourself first.
Saving for College
Paying for their children’s education is something many parents feel compelled to do. Many parents feel that paying for their children’s college education is a necessity when in reality it is a luxury. I won’t disagree that having a college education is almost a necessity nowadays, but that doesn’t mean you should go into debt for your kid’s education. I don’t think a little student loan debt is that bad – I can already hear people up in arms saying “GWAT? All debt is bad debt!!!” And they’d be right for the most part, but student loans can teach kids financial responsibility while building their credit history without having to use credit cards and other type of consumer debt. But that’s just my opinion. (Lisa Aberle at Get Rich Slowly wrote a great piece on why they’re not saving for their children’s college education – check it out.)
For those parents who want to pay for their children’s college education without having to break the bank, the answer is simple – start saving early, often, and have the right plan. Since tuition rate of increase is larger than the rate of inflation (5% vs. 3% per year), saving for college in a regular savings account is not ideal because the rate of return of the typical savings account is currently less than 1%. Our best bet is to have a 529 plan, a Coverdell Education Savings Account, or a UGMA/UTMA.
529 Plans come in two flavors: Prepaid Plans and Savings Plans.
In the Prepaid plan, you pay for future college credits at today’s rates. So if a college credit is $100 today but $500 when your kid is ready to go to school, you save $400 per credit. The disadvantage of this plan is that you have to commit to a specific school – but what if your kid wants to go do a different school? It also only covers tuition and fees – not room and board.
529 Savings Plans are therefore a much better deal. These are state operated education savings plans that allow anyone, regardless of income, to contribute to a special savings account that works very similar to a retirement account. There is no annual limit on the amount we can contribute and the lifetime contribution is about $300,000 for most states. Our after-tax contributions to 529 plans are not tax-deductible, but the growth is tax free and we don’t have to pay taxes on the withdrawals if the money is used for educational purposes – tuition, books, housing, etc.
Even though 529 plans are state operated, we don’t have to choose our state’s plan if we don’t want to. We can choose any state’s plan and use the funds in the school of our choosing. For example, we can have a plan in Florida and go to school in Alaska if we want to. Different states have different plans with different investment options – mutual funds, bonds, CDs, savings account, etc. – so we should choose the one that best suits our needs. Some states have tax advantages for its residents so check out what your state has to offer first and weigh it against the benefits of plans offered by different states.
Besides the tax benefits, another great advantage of 529 plans is that you are the owner of the plan and can name a beneficiary of your choosing. So if your child decides she is not going to college or gets enough money in grants and scholarships that she doesn’t need the money, you can switch your beneficiary to another family member – other siblings, step child, niece, nephew, cousins, in-laws, or even yourself if you want to go back to school. Also, only less than 6% of assets within 529 plans are taken into consideration by financial aid officers when evaluating your request for financial aid.
Some 529 plans allow contributions as low as $25 per month to make it easier for just about anybody to save for college. If you start early and save often, you might not need to save that much in order to have enough to pay for school. Remember that compounding is your best friend. If you invest $100 a month for 18 years assuming a rate of return of 8%, you would have almost $45,000 for college – almost $90,000 if you invest $200 a month. Also, anyone can contribute to your plan – grandparents, aunt, uncles, etc. – so instead of getting ten different toys for Christmas and Birthdays from grandma, you could ask her to get just one and to make a small contribution towards your child’s college education.
Since 529 Savings Plans are investment accounts, treat its allocations as you would your retirement account – somewhat aggressive at first (almost all stocks) and conservative as your child approaches college age (mostly bonds and safe investments). You don’t want to have all your funds in stocks when your child is a Junior in High School and find out the market took a dive and you lost half your savings.
Coverdell Education Savings Account
Coverdell ESAs are another great choice when saving for college. They offer superior investment flexibility than 529 Plans with potentially lower costs and the fund could be used for elementary and secondary school costs as well as college.
The difference between ESAs and 529 Plans is that you can only contribute $2,000 a year per child (there’s a 6% tax on contributions above the limit), the ESA assets are not revocable (funds only go to the beneficiary and cannot come back to you), the funds must be used by age 30 or you pay 10% penalty on the remaining amount, and once your child is over 18 years of age, he/she is the one that gets rights to change beneficiaries.
The Uniform Gift to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA) are a way to transfer assets to a minor. Although UGMA/UTMA accounts are not designed specifically as a way of saving for college, many investors use them for this purpose. UGMA/UTMA are great because it allows minors to own securities without needing an attorney to write up a special trust, but I think they’re a bad choice for financing college.
The major drawback of UGMA/UTMAs is that the account/assets go towards the beneficiary at age 18 and he can use the money however he wants. So if Timmy decides to take that money and travel the world instead of using it for college, there’s nothing you can do to stop him – a karate chop to the throat could slow him down though. Also, since UGMA/UTMAs are owned by the child, 20% of the assets within the account are taken into consideration by financial aid officers while evaluating your request for financial aid – compared to 6% within 529 plans.
UGMA/UTMAs are not as good as 529 Plans or ESAs but they are better than nothing. A great resource for information about the different plans and to compare all the state’s options is savingforcollege.com.
Any of the options above are good ways to save for college, but one thing is clear – the earlier you start, the less strain it will be on your wallet. If you can’t tell, my favorite is the 529 Savings Plan and what better day to post about 529s than on 5/29. See what I did there?
I don’t want to sound like a broken record, but I can’t stress this enough – make sure you have a fully funded emergency fund, are saving enough for retirement, and have your finances in order before saving for college. If your child wants to go to college, they will find a way. But if you don’t have enough money to take care of yourself when you retire because you used it all on your children’s education then you might have to depend on your children financially.