When clients consult a financial professional, one of their most common goals is to put their children through college. They have questions on everything from how they should save to when they should start saving. By tailoring your savings strategy to your specific situation—income, number of children, timeframe of their education, and risk tolerance—you can help optimize for growth and potentially set your child up for success. Let’s take a look at some popular college saving options, tax implications, and how you can balance saving for your children’s education with other financial goals.
The Cost of Education
You don’t have to be a parent saving for college to know that education costs have increased dramatically over the years, particularly in the last decade. Over the past 58 years, the average cost of tuition (at both private the public schools) for a four-year undergraduate college degree in the United States has more than tripled, increasing from $508 in 1964 to $14,688 in 2023, accounting for inflation.1 The steep cost of tuition shows in enrollment numbers as well. Since the COVID-19 pandemic, one million fewer students have enrolled in four-year universities, well below pre-pandemic numbers, which were already on the decline.2 High school students are often daunted by the rising costs of tuition, and many of them are beginning to doubt the value of a traditional four-year university education in the first place, choosing instead to find more direct pathways into the workforce.3 Recent studies have found that 75% of high school students say they would rather pursue a two-year degree or technical certificate instead of a four-year university.4
While there’s nothing wrong with getting an education outside of the traditional university setting, the fact that students and their families are deterred by the cost of education and crippling student loan debt is a major concern for the future of our young people. How can families lessen the burden? One of the more popular savings solutions is a 529 college savings plan (also known as qualified tuition programs and Section 529 plans). There are two types of plans: the education savings plans and the prepaid tuition plans, and they both do exactly what their name implies.
Contribute to a 529 Education Savings Plan
Education savings plans grow on a tax-deferred basis, but the withdrawals are tax-free when used for qualified educational expenses, such as tuition and fees, housing and food, books and equipment, etc. Anyone can contribute to the fund, meaning it’s a great way to invest inheritance or monetary gifts to the children from other family members like grandparents, however, be aware that depending on the state you live in, you may incur a gift tax. While there is no minimum contribution limit for a 529 plan, there are maximum balance limits that vary from state to state.5 The funds grow over time through interest with one caveat: if the funds are not used on qualified educational expenses, a 10% penalty on the funds will apply, along with ordinary income taxes.6 There’s no age requirement for the beneficiary of a 529 plan. That means that parents can open the account whenever they wish, even before a child is born, and then simply make the child the beneficiary later in life. Any unused funds can be used for graduate education or rolled over to another beneficiary without any tax penalty.7 As of 2024, unused funds can also be rolled into a Roth IRA, though that practice does come with certain limitations.8 Beneficiaries can also use up to $10,000 annually for tuition and fees at private or religious K-12 schools, as well as up to $10,000 for qualified student loans in a lifetime.9
Consider a 529 Prepaid Tuition Plan
The 529 prepaid tuition plan works a little differently. The idea behind this one is that parents can lock in today’s tuition prices for tomorrow’s education at an in-state school. Essentially, it protects your child’s education costs from inflation and rate hikes. There is a catch, however: this type of plan only locks in tuition and the mandatory fees of your child’s education; it does not cover things like room and board, equipment and books, or any other costs associated with their education. Unlike the 529 educational savings plan, you cannot use your prepaid plan to pay for K-12 education or to repay student loans. All in all, the 529 prepaid plan might not be quite as versatile as the 529 education savings plan, but it does come with more of a safety net. Namely, some 529 prepaid plans are backed by the state you live in to protect your investment if the plan sponsor suffers a financial shortfall, whereas 529 education savings plans are not backed or guaranteed by anyone.10 Note that we said “some.” This feature differs from state to state.
Allocate Funds to a Custodial Account
Parents can open a custodial account under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). These types of accounts can be created by an adult at most banks, credit unions, or brokerage firms, but be sure to pay attention to the specific regulations surrounding custodial accounts in your state. The maximum age range is anywhere from 18- 24, depending on the state you live in.11 These days, about 2% of parents use custodial accounts to save for their children’s education.12 As the custodian of the account, the child would need your approval to manage the account or buy and sell investments, but anyone can contribute to the account, including family and friends. Once the child reaches the age of majority in your state (again, that could be from age 18-24 according to the rules in your state), the accounttransfers over to their control. The main difference between this type of savings account and all the others we’ve discussed is that this account isn’t specifically designated for college.13 There is no penalty if your child wants to use the money for something else after they are of age. This can be a great feature if your child gets a special opportunity like a fellowship or a study abroad opportunity, but it can also be a bit of a catch-22 if your child doesn’t already know how to spend and save wisely. If you do opt for this type of account, use it as a teaching model and let your child have an active role (through you) in how the account is managed so they can learn good money habits while they’re young.
Understanding FAFSA
Financial professionals can make understanding things like financial aid, scholarships, and grants simpler. They can explain how your savings and assets might affect your children’s eligibility and help you develop strategies to get the most out of the system. For example, custodial accounts tend to reduce a prospective student’s financial aid allocation more than 529 plans do. Custodial accounts are seen as the student’s property, not the parent’s, and therefore can decrease aid by as much as 20-25%, whereas only 5.64% of funds held in a 529 plan are counted when determining federal aid.14 Think of it this way: if you have $10,000 in a 529 plan, your child’s aid could be reduced by $564. However, if you have $10,000 in a custodial account, your child could have $2,000 or more deducted from their FAFSA allocations. Yes, it’s true that a college savings fund could reduce your child’s eligibility for federal aid, but in general, the benefits of having a college fund often outweigh any potential strikes against your child’s financial aid.
Balancing College Savings & Other Financial Goals
While your child’s education is a singularly important factor to plan for, let’s be honest, it’s not the only one. You could also need to save for your own education or have more than one child’s education to worry about. There’s also the matter of paying down your mortgage or saving for a house in the first place. You might have debt or a medical condition that costs you more in healthcare. Finally, there’s your retirement to consider, and like your child’s education, the sooner you can save for that, the better. How do you manage it all? Firstly, it’s important to make sure that you’re setting realistic goals for yourself. A financial professional can help you analyze your financial situation, including your income, expenses, debt, risk tolerance, and goals against a timeline that makes sense for you and your family. The last thing you want is to sacrifice one goal for another, so your financial professional can create a strategy that helps you to make progress toward all your goals simultaneously. Of course, as the children get older and your financial situation changes, you’ll want to have regular check-ups with your financial professional so that they can adjust your strategy as needed.
When to Start Saving
Parents have a lot to think about when it comes to sending their children to college, but one of the most common questions they ask is when they should start saving for college. Like most things in the financial world, time is the most valuable commodity that you have, so the sooner you start, the better off you’ll be. You want to be able to take advantage of the compounding effect of time on your investment. Let’s look at an example. Say that you need to save $100,000 by the time your child is 18 years old. Your savings account allows you an annual return of 6%. If you start contributing to this account the year your child is born, then you will put away about $256 a month for their education. Now let’s say that you waited until the child was 8 years old to start saving and let’s assume the same rate of annual return. You would have to save over $600 a month to reach the same exact goal. The bottom line is, no matter how much you can save, it’s better to do it sooner rather than later so you can take advantage of the compounding interest.
Conclusion
Saving for your children’s education is a lofty goal, but it’s certainly not an impossible one. Working with the right financial professional can help you make it happen. With the right guidance, you can skillfully navigate your options, tax implications, and how to balance other priorities with the most important one: your child’s future.
Sources
1National Center for Educational Statistics Data Sheet, Accessed March 13, 2024 https://nces.ed.gov/programs/digest/d23/tables/dt23_330.10.asp
2,3,4CNBC, May 24, 2023 https://www.cnbc.com/2023/05/24/collegeenrollment-continues-to-slide-as-a-four-year-degree-loses-appeal.html
5,6,7,8,9,10FINRED, 529 Fact Sheet, May 17, 2023 https://finred.usalearning.gov/assets/downloads/FINRED-529Plans-FS.pdf
11,12Saving for College, October 27, 2024 https://www.savingforcollege.com/article/are-custodial-accounts-a-good-option-for-parents-saving-for-college
13Saving for College, October 27, 2024 https://www.savingforcollege.com/article/are-custodial-accounts-a-good-option-for-parents-saving-for-college
14Yahoo! Finance, January 9, 2024 https://finance.yahoo.com/news/financialadvisor-help-save-child-230609151.html
