Every parent wants to provide for his or her child’s education, a worthwhile goal though one that can seem overwhelming. We’re here to ease your mind. Put the baby down for a nap, take a deep breath, and consider these simple steps.
Step one: be realistic.
This will help a lot. Settle in your mind that paying for your child’s entire education can be daunting, even unrealistic. If you saved $50/month with no interest (which may be a difficult amount for some parents) for the next 18 years, you would only have $10,800 by the time your child graduates high school. In 1993, the average cost of a 4-year college education was roughly $30,000*. Today it is roughly $88,000*. Imagine what it will be 18 years from now! But don’t panic. That just means your $10,000 is a supplemental savings plan to use in conjunction with other resources. The key to maximizing this is to be wise about how
Think twice before you put the money in the baby’s name.
Many people make the mistake of starting a savings account in their child’s name at an early age. This can present multiple issues, not the least of which is that when your child turns 18 he can do whatever he wants with that money. You could find yourself having saved for 18 years to buy a road trip sedan. But a greater problem with this plan is that when your child attempts to apply for college grants and loans, this large sum sitting in his savings account may hinder his ability to take advantage of those assistance programs. If you need to segregate the funds to make sure you don’t spend it, that’s totally fine. But there are better ways to do it.
What about educational savings plans?
Another option is a tax-qualified savings vehicle such as a 529 Plan, or an Educational IRA. These are perfectly legitimate savings strategies, with pro’s and con’s.
PROS: The plan is growing throughout its lifetime, and as long as the money is used for education (in the case of a 529 plan, it must be used for higher education), you can pull it out tax-free**. You own the plan, it’s tax-deferred and your child is the beneficiary. You control the assets and can change beneficiaries if you choose (for instance if the intended child decides not to go to college, but another child does). Using our $50 per month example and a 5% return, you’d end up with about $17,000 at the end of 18 years, of which you contributed $10,000. You will never pay taxes on that additional $7,000 as long as it’s used for education expenses (room, board, tuition, books – not a car or food). Finally, if you decide to use the money for something else, you can withdraw it, although you will pay taxes and a 10% penalty on the gains (the $7,000).
CONS: There are two potential problems with a 529 Plan or Educational IRA: the first is that you are limited to educational expenses only for its use. But more importantly, these accounts still hold potential to inhibit the use of college loans and grants. Schools, when looking at applications for financial aid, look at the parents’ assets as well as the student’s. These plans count as assets for you, and therefore prevent you from maximizing the amount of assistance benefits your child may receive.
As a final note regarding 529s and Educational IRAs, these may be better accounts for grandparents who can deposit a large lump sum (as opposed to small incremental contributions), which will allow it to grow much more over the same time period.
What are some other options?
If you’re not already using it for your retirement, a Roth IRA may be an option. Here’s why:
- Although it will end up being the same amount of money (using our $50 per month, 5% return model), you can pull the contributions (the part you put in) out tax-free and penalty-free at any time, for any reason.
- You can pull out the gains (that extra $7,000 from our earlier example) penalty-free if they are being used for qualified higher education expenses, but you do have to pay taxes on them. However, assuming your gains are small, the taxes will be too.
- You also have the option to pull out the first $10,000 in contributions with no taxes or penalties, and leave the gains in the account to continue growing if you choose to.
For some, such as parents who can only save small amounts per month, the benefits of the Roth IRA may outweigh the cons of having to pay taxes on the gains, allowing your child more leverage to use the money you saved in conjunction with other types of assistance.
There are many other options as well. Some parents choose to purchase a life insurance policy and dramatically overpay the premium, which has the double benefit of building up a cash pile you can pull out later, and protecting your family in the event of tragedy.
Of course these are all high-level overviews of life situations and we all know life is more complicated than that. That’s why we strongly recommend you sit down and talk with a professional who understands all the available options before you make any decisions about saving for college. A financial advisor can present the options in a way that fits your lifestyle and takes future possibilities into account. But we hope this gives you a place to start. What are your savings questions and ideas?
** Consult a tax advisor for actual tax benefits and information