The amount of attention given to the growing student loan debt in the US has prompted many parents to prioritize college savings for their children. And while there are various vehicles used to save for college, the 529 plan has emerged as the frontrunner.
But before we jump into the benefits of using a 529 plan, let’s cover the basics of saving for college.
Make sure your college savings goal is part of your overall financial plan.
Just like the other goals in our financial plan, our college savings goal should be specific and prioritized along with everything else. Determining how high of a priority you place on college savings is a personal decision that only you can make. For some, there is enough room in the budget to fully fund your goal. For others, you may have to make adjustments in order to hit your target. Just remember that taking away from your retirement savings is usually not advised. Sure, you helped your kids go to college debt free, but will you have to move in with them in retirement because of it? Seeing the impact of college savings on your overall plan will help you make the decision of how much to allocate towards this goal.
The amount you need to save will vary, and starting early is key.
If you have decided to save a set amount of your budget each month, then the decision of “how much” is pretty clear. But if you intend on funding an amount based on the cost of future tuition, then the amount you need to save will differ depending on where your child will attend college, how much you are willing to fund, as well as their potential to earn academic or athletic scholarships. Some of these factors (e.g. scholarships, school choice, etc.) will probably be decided during the last year or so of high school, often too late in the process to make major adjustments to savings. So how do you know what to save with so many unknown factors?
First, start with realistic assumptions. Sure, all of us would like to think that our kid is going to be the next Stephen Curry, but the chances of getting a scholarship to play at the college level are slim. According to the NCAA, only about 2 percent of high school students earn scholarships to compete in college. And while the chances of receiving an academic scholarship are much greater, it is rare that it will cover the entire cost of tuition. Key takeaway: don’t rely on scholarships, especially early on.
Second, location, location, location. Are you dead set on sending your kids to private or out-of-state schools? Then expect to pay much more in tuition. But the reality is that most students elect to go to in-state schools. Not only are they close to home, but tuition is usually much less for in-state students.
Once you have an idea of what school they may attend, you can easily find the current tuition rates. You (or your financial planner) will then take that rate and make adjustments for inflation. Your financial planner will probably use an inflation rate between 4 and 6 percent. Here’s a good tool to help you figure all of this out.
Now that we know the future amount of savings we will need to pay for college, we need to figure out the best way to save for that amount.
Making a lump sum investment would be the most ideal way to save, however, most people will find it easier to invest monthly in order to reach their goal. Whichever way you choose, starting early is best. The earlier you start investing, the lower your required rate of return will be. This is because you are giving your money more time to compound.
By starting early, you’ll also benefit from a longer time horizon, which allows you to have a more aggressive asset allocation. Work closely with your advisor to determine the proper asset allocation with regard to your savings goal, risk tolerance, and time horizon. Also be aware of the fees of the investment options in your plan.
Pick a savings vehicle designed to meet your goal.
Like your retirement savings, the biggest factors are your rate of savings and sticking to your plan. However, the vehicle you use to accumulate these savings can help you achieve your goals. While there are multiple savings vehicles that can be used, the 529 plan is usually the most beneficial. Let’s look at some of the benefits that make the 529 plan the preferred choice:
- Tax deferred growth – This reduces taxes and helps earnings compound at a faster pace.
- Tax-free withdrawals – As long as you use the withdrawals to pay for qualified education expenses, you won’t owe any taxes.
- Control – You (the parent/account owner) control the funds. Unlike an UTMA or UGMA account where the funds are the asset of the child, funds in a 529 account are assets of the account owner.
- Transferable – If one child doesn’t use all of the funds in their 529 account, you can transfer the funds to another child or relative.
- Favorable treatment for financial aid – Assets in a parent owned 529 plan are not considered assets of the student. Also, qualified distributions are not counted as income. These factors will be beneficial when filling out the FAFSA.
- State tax deduction – Many states offer a state tax deduction for residents who contribute to their states 529 plan.
These benefits combine to make a robust college savings vehicle. But as with any investment, you need to know how it fits into your overall financial plan.
You will also want to compare 529 plans from each state to determine what option is best for you. Look at fees, investment options, and tax benefits when making your choice.
If you’re ready to get started with a financial plan of your own, click the contact link at the top of the page to schedule a free initial consultation.