Did you know that a child turning 6 is one-third of the way to college? And a child entering 4th grade is halfway towards leaving home. Many people are worried about the big bill awaiting their children when they finish high school. When thinking about savings for college, most people have four main questions. What are they? And how can you save for college?
1. How much should I save?
That’s the big question. It depends on where your child goes to college, what costs you cover, how long they attend college, and how many children you want to send through school. If you assume
· 7.2% investment growth rate
· 6.2% college cost inflation
· $36,098 in-state yearly cost today (tuition, room, board, expenses, books, fees)
· One child is born today and goes to school at age 18 for 4 years
you are looking at saving $875 / month throughout the child’s first 18 years of life. But there are a variety of factors that can influence this number:
· Will you pay for your child to go out-of-state?
· Do you want your child to live at home during part or all of college?
· What happens if your child earns scholarships?
· Do you want to pay for all of Undergrad? Grad school?
It’s important you think through these questions because they affect your financial plan. Being able to answer these questions will help you when you meet with a financial planner.
2. Where should I save my college money?
One of my friends once asked me, “Is there a college savings program where I invest pre-tax dollars, let it grow tax-free, and then don’t have to pay taxes when I use the money to pay for college”. My answer: “I wish!” In the financial planning world, that’s called a triple tax-free investment. It’s the gold-standard. We can’t hit that, but we can get two-thirds of the way there.
529 plans: 529 plans are a good place to invest money for college because you earn a state tax deduction (in Virginia you get $288 back in taxes for every $5,000 you invest into 529 plans). Furthermore, the investments grow and disperse tax-free when used for educational purposes (2 out of 3 – the silver standard). The only downside is 529s are funded with after-tax dollars. If you have more questions about 529 plans, we wrote an entire blog post about them. Feel free to contact us as well.
Roth IRAs: Another option is putting money into a Roth IRA. You don’t get the state tax deduction, but it gives you more flexibility down the road when time comes to pay for college. Realistically, if college costs continue to rise at their current rate, being able to set aside close to $875/month for 18 years for just college (see calculation above) is unrealistic for most families. But setting aside $875/month for retirement could almost be a necessity. This is why Roth IRA college funding could be a good option for many people.
You can pull money out of a Roth IRA as soon as you turn 59 ½ completely tax-free for any purpose if the Roth IRA has had money in it for at least 5 years (the 5 year holding period). You can also pull money out of a Roth IRA before 59 ½ tax-free as long as you only take out less than the money you put into it (the contributions). The growth portion in a Roth IRA is taxable when withdrawn before 59 ½. But educational expenses for dependents do not incur the 10% penalty. Effectively, you are using your child’s college savings to grow your retirement nest egg. Then, you use the contribution portion to partially fund your child’s college.
If your retirement savings are behind your retirement target 18 years from now, you can reduce what you can contribute to college. This allows you to focus on retirement. At Independent Financial Planning, we recommend making sure you fund retirement before funding your child’s education.
The situation gets a little more complicated if you converted money to a Roth IRA (from a Traditional IRA), so please reach out to us before making any decisions.
UTMAs: Another option is UTMAs. These are more flexible college savings vehicles because your child can use them for anything. Some people like UTMAs because they allow you to control the investments much more carefully than in a 529 account. However, what you can do in an UTMA, you can effectively do in a Roth IRA. So, for most people, we recommend the Roth IRA route over the UTMA route.
A (potential) downside is your child gains legal possession of the assets in an UTMA at age 18 or 21 (depending on the state). If you don’t think your child will be ready to handle a large sum of money at that age, you will want to steer clear of the UTMA. Another disadvantage of the UTMA is that taxes will be due on its growth each year, and dividend income/capital gains may be subject to the Kiddie Tax if it exceeds $2,200/year (2021).
Real Estate: Another interesting option is real-estate. If real-estate is your thing and you have the capital to do so, you could invest in a rental property and use the rental income to paydown the mortgage. After 18 years, you could simply say to your child, “Here is this house. You can either sell it for college or use the rental income to fund part of college. Your choice.” During the child’s life, you can annually gift interest in the property to utilize your annual gift exclusion. This gifting would be into an UTMA. While this is unorthodox, if you are experienced in real-estate investing, this poses a creative option for saving for college.
3. When should I start saving?
The earlier you make a plan and start, the better. Early investing let’s compound interest have more time to take effect. It’s also helpful if there is a lump sum available to contribute at the beginning of your saving period. This substantially reduces the monthly savings required to attain your goal. It’s worth asking extended family if they have any desire to contribute to your child’s college savings. If so, they should do it earlier rather than later.
4. How should I invest my savings?
Generally, you want to be in equities (stocks) until your child is around 12 or 13 years old, then you want to transition gradually to a more conservative portfolio over the next couple of years. As your child enters college, you want to reduce the risk posed by stocks, but still give it stable growth. You might even want it to be in purely cash or CDs as your child heads to college. Please consult with a financial planner before making this final decision.
If you have questions about saving for college, give us a call at 571-969-1459. At Independent Financial Planning, our goal is to help you make a plan and execute it. You can learn more about us at ifpinvest.com.
