Saving for Your Kids’ College Education: A Primer

Sometimes my husband and I imagine where our kids might go to college – not because we’re determined to get them into a prestigious or Ivy League university, but because we had so much fun (too much fun) in college ourselves that we’re excited for them to experience it, too.   

Our daydreams came to a screeching halt, though, once we started looking at the actual price tag of college. We were both incredibly lucky to graduate with no student loans, so we were, frankly, clueless about how expensive it was. Right now, our alma mater, Penn State, is $44,242 per year for out-of-state tuition, and that cost will continue to rise over the next fifteen years.

We knew we wanted to start saving for our kids right away, so we opened 529 Plans when they were born. No one specifically told us to do this. We just sort of knew it was the way to go based on our backgrounds. My husband’s in finance, where he’s exposed to the world of money management, and I worked in Human Resources, so I had access to information on retirement benefit plans and other saving vehicles, like college savings plans.

Since we’re not financial planners, though, we’re not about to tell you how you should manage your money. Luckily, our friend Patrick is a professional financial advisor with Impact Fiduciary, and I asked him to talk more about college savings options here.  

Before you even consider putting aside money for your kids’ colleges, make sure that’s actually a wise decision for you. Pat explained all about this in a previous post, “When Saving for Your Kids’ College Is the Wrong Move.” And, of course, do your own research and consult with a financial advisor (they’re not just for rich people) before initiating your own money moves.

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How much?

College has become expensive! In fact, over the past decade, the cost of college has gone up by over 60%!

As a financial advisor and father of two young daughters under three, I have thought a lot about how to tackle saving for college. I’ve seen firsthand how student loan debt can be soul-crushing, career-limiting and even change the calculus of starting a family.

The average student now graduates with $37,000 of debt before ever making a penny! I have seen worse and work with clients who owe hundreds of thousands of dollars in student loans. This has really become a modern ball and chain.

How should you save for your kids’ future, so they can start off on the right foot?

Enter the 529 plan

The 529 plan allows you to save and invest money that will grow tax-free as long as it’s used for education. It’s not just college anymore. The new 2018 tax law changes offer a bit more flexibility allowing you to spend up to $10,000 from your 529 plan tax-free for primary school.

In some states, you can get a tax deduction for your contributions, but, unfortunately, California doesn’t offer one. Since they are state-run plans, you will need to find a state to sponsor the plan.

I typically recommend using the Vanguard plan for my clients residing in California. They offer great investment options at rock bottom costs with a set it and forget it allocation that is managed for you. I love the fact that you can automate the contributions on a monthly basis from your bank account so the heavy lifting is done for you.

How much can I contribute to a 529 plan?

You can invest up to the expected cost of five years of college per beneficiary (i.e. your child who will receive the money). Depending on the state plan, this can be up to $400,000. If you start early, with a decent chunk of savings, it can really make a big difference!

For instance, if you stashed $10,000 under your mattress and put aside another $300 each month, you would have $89,200 stashed away in 18 years. On the other hand, if you read this post and contributed the same amount to a 529 plan invested in the market with a 6% compounded return, you would have $172,906 dollars saved tax-free for college! Compounding interest is your friend and you should take advantage of it! It increases your savings by $83,000 and, best of all, it’s tax-free! Saving money under your mattress or in a regular savings account is not. 

What’s the catch?

The drawback of the 529 plan is that the money must be used for educational expenses, like tuition, room and board, laptops, books, etc. Otherwise, you will be penalized 10% on the earnings when the money is withdrawn. This means the IRS would charge you taxes plus a penalty on any of the earnings or growth. For example, if you put in $10,000 and it grew to $15,000, then $5,000 would be subject to taxes and a 10% penalty if it’s used for something other than education.

Still, the 529 plan does offer a lot of flexibility. Maybe one of your kids decides to run off and join the circus instead of going to college. You can always change the beneficiary to another child, yourself, or any other family member.

Likewise, if your son or daughter gets a scholarship, you can take the proportional amount of the scholarship out of the 529 plan without paying a penalty, or he or she can use the money for a postgraduate degree.

How much should you save?

If your objective is to pay for all of your children’s higher education, then it makes sense to target saving around 50% to 70% in the 529 plan and cash flow the rest (i.e. pay out of pocket with your current income).

When it comes to education, the apple usually doesn’t fall too far from the tree. I recommend averaging out the current tuition from your and your spouse’s alma matters, then adjusting for inflation.

Vanguard has a really useful calculator to help you figure this out. Warning: the numbers in 15 to 20 years can be eye-popping. My wife went to Babson College in Boston and the full sticker price for my oldest daughter to attend would be $570,000. Yikes!

Invest taxable assets instead

Maybe you aren’t 100% sold on your kid going to college. Another option is to just invest in a taxable account. You can do this in a couple ways.

You can open up a UTMA (Uniform Trust to Minors Act) for your kid, which does provide some tax benefits, or you can earmark an investment account in your name that is for the kids.

You will be the custodian of the UTMA until your child reaches adulthood. The drawback to the UTMA is that the money technically belongs to your child and they have full legal control at the age of 21.

Most clients who use this won’t tell the kids about their money until they are at a responsible age like 25 so that they don’t blow it on something extravagant like a new Ferrari.

And who knows? Maybe, in the future, kids won’t go to college, and we’ll all just have chips implanted in our brains a la “The Matrix.” Your kid can then use the funds to start a business or maybe use it as a down payment on a home without the tax penalties that would come with using a 529 Plan for those things. It’s nice to have options.

Bad advice

I’ve heard of people using whole life insurance as a vehicle to fund college. This is a major mistake! Whole life insurance and variable universal life are extremely expensive. Yes, there are some tax benefits, but the costs completely outweigh the positives.

Life insurance is very important, but it should be used to protect your loved ones, not as an investment.

The insurance sales pitch is that the money won’t show up on your financial aid form. Yes, this is true, but only 5.64% of the 529 plan counts toward assets for the kids on the FAFSA form, anyway. If you have $100,000 set aside in the 529 plan then financial aid would only take $5,640 into account.

Insurance agents love these products because they pay a big commission, not because it’s actually in your best interest. Run, don’t walk away.

Financial freedom

When it comes to saving for college, it is really about increasing the financial freedom for your kids, so they can dream big and take risks after school, instead of being shackled by debt. Yes, the cost of education has gone up quite a bit over the decade, but there are a lot of creative ways to limit the impact of student loans and still graduate with a degree from a great college. Online education, community colleges, the potential for free college tuition legislation, and other future, yet to be fully conceived, options (e.g. brain upload?) will hopefully open up the doors to a more educated society with less debt.

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Not sure where to get started? The goal of a financial advisor is to save you time, money, and to take the stress out of financial decisions like saving for college, so it’s worth taking the time to find one like Pat to help you organize your financial life and get on the path to financial independence. Good luck!