Money milestones: How to pay for your child's college education
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Parents of young children have good reason to worry about the rising price of higher education. If you think college is expensive now, the projected future costs might leave you wondering how your kid can afford it — especially since relying on student loans could leave them saddled with debt.
If you want to help your child afford a future college education, you can start while they’re young. The earlier you get started, the more you can help reduce the financial burden.
Here’s how to plan for the cost of your child’s college education.
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There are many ways to save for a child’s future education. You can open a traditional savings account, a high-yield savings account to keep up with inflation, a college-focused plan like a 529 plan or even an individual retirement account.
“Coverdell Education Savings Accounts, 529 savings plans and even Roth IRAs are tax-advantaged accounts that can be used to pay for college. The sooner these vehicles are funded, the more time they have to grow over time,” said Ryan Firth, certified public accountant and president at Mercer Street, a financial and tax services firm.
Firth recommends choosing a 529 plan or Coverdell Education Savings Account in most cases, both of which were specifically created for educational expenses.
What is a 529 plan?
A 529 plan is a tax-advantaged savings and investment account that helps families save for college. Every state offers its own 529 plan, but participants can choose plans across state lines. While contributions to 529 plans aren’t exempt from federal taxes, there may be state tax incentives for participating in the plan offered by your state of residence.
There are two main types of 529 plans:
Prepaid tuition plans let you buy future college credits at today’s tuition rates, locking in what will almost certainly be a lower cost. You select the number of semesters or credits you want and pay for them all at once or through an installment plan. These plans are frequently restricted to in-state residents and in-state schools, but you won’t lose your money if your child attends school across state lines — you’ll be able to change the beneficiary or receive a refund.
The main benefit of prepaid tuition plans is that you’re protecting your child from the rising cost of tuition and you aren’t risking your contributions with investments. The main downside is that the plan only covers tuition and fees. They can’t be used for other expenses like textbooks, school supplies or room and board.
Only a few states offer prepaid tuition plans.
Investment plans are more common than prepaid plans. Your contributions are invested in a portfolio of stocks, bonds and other securities that, ideally, grow until the beneficiary is able to make withdrawals for college. All earnings are tax-deferred and withdrawals are tax-free as long as they are used to pay for eligible education expenses such as tuition and fees, books, software and computers, room and board and more.
Age-based 529 plans automatically shift investments from higher-risk, higher-reward securities to more conservative investments as the plan matures. This reduces the risk of losing money due to a recession or bad investment.
Custom 529 plans allow you to manage investments yourself. While they may offer the potential of greater growth, they require active management and are only suitable for experienced investors.
The main benefit of investment 529s is that the earnings and growth are tax-free as long as the withdrawals are used for eligible expenses, as opposed to other investment vehicles that have limited tax benefits. If the beneficiary decides not to attend college, you can transfer the account to a new beneficiary or withdraw the funds and pay a 10% federal penalty tax.
What is a Coverdell ESA?
Coverdell ESAs can be opened at any financial institution that offers them. Much like 529s, contributions to Coverdell ESAs can be rolled into different investments. Contributions aren’t tax exempt, but earnings and withdrawals are as long as they’re used for eligible expenses.
Coverdell ESAs have an annual limit of $2,000 per year, per beneficiary. There are income restrictions for participating. Withdrawals must be taken by the time the beneficiary reaches age 30 (unless they are a special needs beneficiary).
You don’t have to start saving as soon as you have a child, but it’s a good idea to get started early. The more time you give yourself to save, the bigger your child’s college fund can grow. Whether you have a specific savings goal in mind or you just want to save as much as you can, starting early can help you get there.
Whether you’re building your child’s college fund in a 529 plan, Coverdell ESA, IRA or a plain old savings account, the key is to save regularly and frequently. Add a college savings contribution into your monthly budget, and consider contributing extra whenever you come into some unexpected income. One caveat: Your savings should be realistic for your budget and shouldn’t take away from other priorities.
“Retirement security should take priority over paying for college. Parents should try not to sacrifice their retirement so that they can pay for their child's education. It's easy to borrow money to pay for college, but it's much more difficult to borrow money to fund retirement,” said Firth.
If you’re contributing to a plan with an annual limit, shoot for meeting that limit each year. Another benefit of 529 plans is that most states impose no annual contribution limit — there are aggregate limits that set the total allowed account balance, but these are usually so high that most parents won’t need to worry about reaching the limit.
You can also get friends and family involved in saving. When holidays and birthdays roll around, consider asking for a contribution to your child’s college fund instead of the latest toy or gadget. Over time, gift contributions from other sources can help boost your child’s savings.
Once your child is ready, you can get them involved in saving for college. They will need to be old enough to understand the concept of college and saving for the future, and have a source of income such as an allowance or part-time job.
Encouraging your child to contribute to their college savings is a good idea for several reasons. It can help grow the college fund faster. It can help your child learn about saving and the true cost of college. And it can help them be involved in their own learning trajectory, giving them some skin in the game and motivation to succeed when they actually get to college.
The level of savings your child can contribute depends on finances and what works for your family. But making your child responsible for some part of their college savings will let them experience the benefits of planning for the future and make them understand that college is a significant financial investment.
Just because college is expensive doesn't mean that the full cost is unavoidable. You can start looking for potential ways to lower the cost of college way ahead of time. Once your child’s approaching their college years, you’ll be prepared with some ideas for reducing expenses. Ways to reduce the cost of college include:
Enrolling gifted children in Advanced Placement high school courses that earn college credits.
Having your child attend community college for two years before transferring to a four-year university.
Encouraging your child to get a part-time job to help them afford college expenses.
Working on paying down student loans while enrolled in college to reduce future debt.
Searching for scholarships and grants that will help reduce tuition costs.
“Students might want to consider attending a community college for the first year or two and then transfer to a more expensive college or university where they can complete their degree(s),” said Firth. “A student might qualify for a work-study program, or he could get a private sector job, to help cover a portion of his college-related expenses.”
Here is a detailed guide that explains 529 plans and how to choose one that’s right for your family.
Looking for ways to increase your college savings? Here’s how to save more in five minutes or less.
It is possible to negotiate lower college tuition.
Read our guide to 529 plans in every state.
Image: Aleksandar Nakic (Getty)
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