Via LearnVest By Alden Wicker ~
One of the biggest money worries parents have today?
“How on earth will I pay for college?”
It seems like a daunting task. You want the best education possible for your child, but current college tuition seems like a lot to put away. And with experts predicting that college 18 years from now will cost $361,000 for four years at a private university and $100,000 at a state school, how can you keep up with tuition inflation?
The answer lies in college savings accounts, which provide a place to grow your money quickly and safely, so by the time your wee one is applying to college, you’ll be able to cover a significant portion of their expenses, if not all of them.
College Savings Accounts in a Nutshell
College savings accounts are investment accounts that give you a way to save tax-free for higher education costs. These plans have two key players: the plan’s owner (in this case, you) and its beneficiary (your child). As the owner, you will receive whatever state tax benefits are available for contributions (there are no federal tax benefits for such savings plans), while the beneficiary of your plan will get to use the funds.
It’s important to note that these are investment accounts, not traditional savings accounts. You want your money to grow, and at a faster pace than inflation, which is around 3% a year on average. (And college tuitions are rising at around 6% a year–and some at almost 8%!) If you tried saving up for your child’s education in a traditional savings account, which as of August 2012 earns only 1% in interest at the most, by the time your child is ready to go to college, your money would actually be worth less than when you put it in there!
Investment accounts get around this problem by growing at roughly the pace of the market. Based on historical averages, you can assume that it will grow at around 7% a year, depending on the investments you choose. So by the time your child is ready to cash it out, you will likely have more in there than what you put in.
Why Parents Need to Understand College Savings Accounts
There are two main reasons you, as a parent, need to understand college savings accounts:
1. Because college is important for your child.
If you want your child to have all the opportunities you had and more (who doesn’t?), then college is the one proven way to make that happen. Children born at the bottom rung of the economic ladder who go to college are more than three times more likely to rise to the top than children in the same socioeconomic class who don’t go. A degree also makes people raised in a middle or higher economic group significantly less likely to lose ground. In other words, while growing up in an upper-middle-class household helps your child’s odds of staying relatively wealthy as an adult, having a college degree will likely ensure a secure future.
2. Because, if you save for college in advance, you’ll pay less overall.
You might be hoping that once your child gets within reach of college, you can fund his or her education with a combination of loans, grants and scholarships. But according to FinAid.org, gift aid from the government, colleges and universities and private scholarships pays for only about a third of total college costs.
You could have your child take on student loans to pay for the rest, but this is much more expensive. FinAid.org estimates that if, in the years before your child enrolls in college, you save $200 a month for ten years at 7% interest, your child would then have $34,819 to use. But if you borrow the same amount at 6.8% interest and pay it back over ten years, you’ll be making payments of $401 a month.
There’s also no guarantee your student or you will be able to pay it off, especially since students loans have become an untenable burden for graduating students. Nearly three in ten student loans are currently in default. You cannot discharge student loan debt in bankruptcy. And middle-aged Americans are among the people struggling the most with student loans right now–because they took out loans beyond their means to finance their kids’ education.
The solution is to start saving in a college savings plan before your child goes off to college.
The Types of College Savings Accounts
There are three main kinds of college savings accounts you need to know:
529 College Savings Investment Plans
A 529 Savings Plan—named for the section of the Internal Revenue Code that created it—is a type of investment account provided by your state that allows you to save for your child’s college education, tax- and penalty-free. Some key characteristics:
- It’s available to you regardless of your income level.
- You can use the funds to pay specifically for your child’s college-related expenses, including tuition, fees, room and board, books, supplies and equipment.
- If you use the money on anything else, you will be subject to heavy penalty fees of up to 10% on the earnings, plus you’ll have to pay federal income taxes on the earnings. Additionally some states might even include an additional 10% penalty for early withdrawal.
- It varies by state, but contribution limits are high, up to $360,000 total. But if you contribute more than $13,000 a year, your contribution will be treated as a gift and taxed. (A married couple can donate $26,000 per beneficiary.) Or, you can contribute five years’ worth of “gifts” in one year ($65,000 for an individual or $130,000 if you’re married), and not incur a gift tax as long as you don’t contribute anything else for the next four years.
A prepaid plan is a form of a 529 that is becoming less common, and it probably makes sense for you if you believe your child will attend an in-state public college. The differences are:
- You’ll get a locked-in price at the current average rate of tuition at state public schools (though some states will charge you extra for the privilege), and if your child actually does go to an in-state public college, the plan will pay for tuition and required fees based on the average public university rate in your state.
- If your child decides to attend a private or out-of-state college, this type of plan would typically pay the average in-state public college tuition, and you will be responsible for any difference in price.
- Most prepaid plans can’t be used to cover other expenses associated with school, such as room and board, without penalties.
A Coverdell account differs from a 529 investment plan in that:
- Only $2,000 a year total can be contributed, whether the full $2,000 comes from you or $1,000 comes from you and $1,000 from a grandparent.
- You can use the money in the plan for qualified primary and secondary education expenses.
- You can’t contribute if your income is more than $110,000 singly or $220,000 if you file taxes jointly with your spouse.
- You manage the investments yourself instead of handing them over to an investment manager.
Given these limitations, you should probably only choose a Coverdell if you would like to use it to pay for private K-12 education for your child as well. You also have the option of opening a Coverdell in addition to a 529 plan and contributing to both.
Your Questions About Savings Plans, Answered
1. How should I prioritize saving for college over other financial priorities?
You should always max out your retirement account first before putting money toward your child’s 529. This is for two reasons:
- Your child can always apply for financial aid, but there is no assistance or loans for retirement.
- You can always take money out of your retirement account to pay for your child’s college, although you’ll most likely pay hefty penalties to do so.
2. When should I start investing?
As soon as possible. As with all kinds of investing, one of the key ingredients to making your money grow is time. Because of the power of compounding interest, starting just a few years earlier could make a difference of tens of thousands.
3. What if I open an account and my child doesn’t go college?
You’re allowed to change the beneficiary of a 529, usually at least once a year, as long as it’s to another family member–to Child No. 2, for example, or even yourself! (If you decide you want to use the funds for your own education, whether for a bachelor’s, master’s or higher degree, you just need to change the beneficiary to yourself.) Most policies also allow you to roll over the amount in your 529 to another 529 plan.
4. Will my 529 plan affect my child’s chances for financial aid?
Yes, but only slightly. If the 529 plan is owned by a parent (as opposed to, say, a grandparent), up to 5.6% of assets in that plan will be assessed for financial needs.
How Much Should You Save?
If you’re ready to get started saving, use this calculator to determine how much you need to save each month to get to your college savings goal. Or, you can play with the numbers to see how much you’ll be able to save with what you have available in your budget next month. Once you’ve figured it out, go into the Money Center and set up a Priority Goal to start putting that money away.
With the right planning, you can send your child to a high-quality college that will set them up for success. But don’t put aside your retirement goals to save for college–your child will feel the stress and burden too if you get to retirement age and you don’t have the financial means to support yourself!
LearnVest is the leading lifestyle and personal finance website for women.