The 4 Best Ways to Save for Your Child’s College Education
According to EducationData.org, the average cost of a four-year university education in the United States is $32,889. This amount has grown by an average of 5.2% per year over the past two decades, meaning that students will have to pay $54,600 in 10 years at the same rate of growth, and that a four-year education will cost an average of $90,600 in 20 years.
These are shocking and sobering figures for parents everywhere. For many families, numbers like these reveal a stark choice: start saving for your young child's education or face six-figure debt in a decade or two. That level of debt can be a life-long burden, forcing them to make huge payments dozens of years early in their careers and losing opportunities that can cost them later.
What can a parent do to help? Should they save for their child's education, and if so, how much?
Is saving for education more important than saving for retirement?
Many parents face two opposing goals. They want to save for their retirement, but at the same time they also want to prepare their children financially for the heavy costs of university. With a limited budget, it often comes down to a choice: do we pay for our pension, or do we finance their education?
The best strategy is a hybrid of the two. Finance your pension to the point where you have a healthy pension at the right time at retirement age, and then use money to save for a child's education. For most people that means that you have to save 10% of your salary for retirement, and then you may have to save extra money for education.
Why choose this approach? By making sure that your pension is taken care of, it is very unlikely that you will be a financial burden for your children later in life. Not only does your retirement savings take care of you, it also takes care of your children in the sense that they don't have to worry about you or your finances later on and can focus on their future.
First take care of the basics of your retirement savings and then continue saving for your children's education.
How much should a parent save for his or her child's education?
The first step should be to assess how much of your child's education you actually want to cover. Do you want to pay all that? Do you want to share it with your child? Is there a dollar amount you cover, such as education at a local state university, while your child has to pay the rest? There is no correct answer. It comes down to what you're worth. Some parents want their children to understand that their education isn't free - that it has a real price. Other parents want their children to have no financial burden after graduation. What matters is what you think is important. Think about this as early as possible.
The most important factor, no matter how much you save, is that you start as early as possible. Start saving for college when your child is a baby, if possible. If your child is already over the age of childhood, start saving right away, no matter how small - you can adjust your savings later.
Why is this so important? The sooner you start saving, the more time your savings will have to grow and thus the less you will actually have to contribute to achieve your goal.
How do you set your goal? Start with an estimate of the costs of a university education. If you are saving for a newborn, an average education could cost about $90,000 by 2040. An older child will be closer to $60,000 in 2030. Ask yourself what part of that goal you want to cover, and what part they need to cover for themselves. That gives you your goal.
Then take that goal and use an investment calculator to estimate what you need to save. Your initial investment is $1, your years to grow is the number of years before they start college, and use 7% as your interest rate, compounded on an annual basis. For example, if your child is a newborn and you want to save $90,000 for them over the next 20 years, you need to contribute $184 per month to something that pays a 7% return.
How can you save for your child's education?
Now that you've decided how much you need to save, the next question becomes where to put that money. There are several great ways to save for a child's education. Here are four that I recommend.
Open a 529 college savings account
With a 529 school savings account you can save for your child's educational needs without having to pay tax on the investment gains. In some states, they offer additional tax benefits, allowing you to deduct contributions from your taxes. Using a 529 plan is easy once you know the basics. Within a 529, you can choose from a variety of investments, although most bills offer a simple targeted investment plan that optimizes investments for you based on a high school graduation date. Using a 529 when it's time to graduate is also easy; your college or university will work directly with the plan. A 529 is the best all-round option for most people.
Open a Coverdell
A Coverdell education savings account is comparable to a 529, but with some important differences. Unlike a 529, each person contributing to a Coverdell is limited to $2,000 a year in contributions, although you can contribute $2,000 a year to a Coverdell and additional amounts to a 529 in the same year. Also, you cannot use a Coverdell if you earn more than $220,000 a year as a married couple or $110,000 a year if you are single. However, a Coverdell gives you much more control over your investments. If you want to study the investment opportunities and optimize your plans, this can be a good choice for you.
Use a regular investment account
A disadvantage of both the 529 and the Coverdell is that if your child does not need the money for education costs, there is a tax sanction for non-education related withdrawals from the account. With a regular investment account you get around this - you have to pay tax on all investment gains, but you do not have to pay an additional tax penalty if the money is not used for educational purposes.
This is a good option if you want to be able to hedge your bets, but it has a big drawback. If your student applies for more financial support using the FAFSA, assets in a regular investment account will negatively affect the student loans and scholarships they can get. This means that they may need to make more use of private student loans, which may have higher interest rates and stricter requirements.
Use a Roth IRA
Another possibility is to use a Roth IRA for educational savings if you don't already use one for retirement savings. In this case you open a Roth IRA in your name and contribute to it annually. When your child is ready for university, you can then withdraw your contributions without penalty and use that money to help pay for university. If you contribute $5,000 a year from birth, by the time your child goes to college the contribution will be $90,000. The extra money earned would stay within the account and strengthen your own retirement savings, although it won't be enough on its own to support you. This should be used in addition to other retirement savings vehicles such as a 401(k). Consider this option if retirement savings is a major concern for you.
Was this article helpful? 32 Posted by: 👨 Kathleen J. Patton