Saving For College

One of the primary goals young couples have is to pay for their child’s college. With these expenses increasing at an alarming rate, you may feel like you’re swimming upstream. Much like saving for retirement, saving for college needs to start as early as possible. Each year that passes by is one less year your savings has the opportunity to grow for you.

Creating a college savings plan needs to consider all factors at play. This includes the cost you are wanting to cover, the funding sources you have available, and the various growth rates of costs and savings.

To start, get a clear picture of college costs today. You can use the Department of Education’s College Scorecard to lookup specific colleges. This will show you the average annual cost for college in your area or the college you’d like your child to attend. Included in the average cost is tuition, room and board, textbooks, and other expenses due to attending. Unfortunately, you will need to adjust this number for inflation until the year of attendance. I typically assume 5% per year.

Which accounts do you use to save for college? The most popular college savings account is the 529 plan. This is an account that allows you to contribute after-tax dollars, invest those dollars on a tax-deferred basis, and eventually withdraw the proceeds tax-free for qualified education expenses.

I prefer to use a three-legged-stool approach to college savings. What does this mean? You pay for college with three different sources: 529 plan, taxable brokerage account, and miscellaneous. The miscellaneous leg is made up of current cash flow, scholarships, and tax credits while your child is attending college.

The first third of your total college savings should go into the 529 plan. The tax advantages make this account a great way to start saving. Why not fund all of college with a 529 plan? I prefer to maintain some flexibility. Any money that goes into a 529 plan needs to be used for qualified education expenses. If you save too much into a 529, any growth that gets withdrawn for other purposes is subject to income tax plus a 10% penalty.

The second third of your savings should go into a taxable brokerage account. There aren’t any tax advantages to this account, but flexibility is maximized. If you need to use the funds to pay for your child’s college expenses, then the money is available for that. If you don’t need the money for college, you maintain ownership of the account and can use for other needs.

The final leg of your college funding will come from current cash flow, scholarships, and tax credits. Current cash flow is the income you’re earning while your child is in college. Scholarships are available both in need-based and merit-based forms. The two tax credits you may be eligible for are the American Opportunity Tax Credit or Lifetime Learning Credit. These can provide up to $2,500 and $2,000 in annual tax credits, respectively.

How does this all stack up? Let’s assume you have a newborn child that is going to attend a college with a total annual average cost of $20,000 today. In 18 years, this cost grows to about $48,000. To fully fund college, this adds up to about $200,000, due to increasing costs while in school. With the three-legged approach, you need to accumulate ⅔ of this amount by age 18, or $133,333. The remaining balance gets funded by the third leg of the stool. Assuming an annual growth rate of 5% on your investments, you will need to save $381 per month if you start at birth. What happens when you wait to start saving until your child is 5 years old? The required monthly contribution increases to $608.

The remaining $66,667 third leg still needs to be funded. This is $1,389 per month over the course of four years. Your monthly savings of $381 will continue, plus about $400 per month will be freed up with the child out of the house. A $2,000 annual tax credit saves another $167 per month. Your ending balance comes to $441 per month. This can be funded by scholarships, your child’s earned income, or student loans.