College Costs & Savings Strategies
As summer winds down, kids head back for a new school year. Among the pencils, paper, and other supplies, it’s important to equip your child with another tool: a higher level education.
College education is a game changer in an individual’s economic outlook. Statistically, a college education means lower unemployment, higher median income, greater access to employer-provided health insurance, and lower incidence of poverty compared to those without a college degree.
Many parents, schools, and communities emphasize the importance of higher education in creating access to opportunities and wealth. But we can acknowledge that paying for college is not easy.
The Price Tag
The cost of higher education depends on where you go. On the low end, public two-year schools average $3,440 per year. In-state public university tuition averages $9,410 per year. Attending out-of-state public universities can add a significant premium, often resulting in two or three times higher compared to attending in-state. The average tuition for out-of-state public universities is $23,890 per year. Private universities top the charts at an average tuition of $32,410 per year. And these are just the published prices.
Source: College Board
Then you tack on other expenses like room and board, supplies, books, and other expenses. This amount varies by school location and lifestyle, but this could be another $10,000-15,000 per year on top of tuition.
Source: College Board
Students may receive grant aid and scholarships that lower the actual cost of tuition and fees. Keep in mind that tuition has increased at 4% annually historically, but we expect about a 3% annual inflation rate going forward.
Source: College Board
All in all, a student attending a 4-year public university one year from now can expect to pay nearly $100,000 to obtain a 4-year degree. You can use Vanguard’s tool to estimate how much college will cost for your loved one.
So we know college education is an important indicator in the wealth building cycle, and we know it’s expensive, so how do we pay for it?
How to Pay the Price
There’s not a single way. On the contrary, there will probably be multiple pools from which to pay for college. From college savings, to grant aid or scholarships, part-time student income, income from parents during school, and student loans.
On average, students with a bachelor’s degree who take out loans leave school with an average of $28,650 in student loans, and 57% of graduates have student loan debt. As we see with many Millennials, individuals with student loan debt may have high bills, be more likely to continue borrowing money from their parents as adults, and may delay home ownership or marriage.
The point is, by helping to pay for college, parents can limit the debt burden a student takes on in pursuit of their college education. Parents have varying beliefs about how they should contribute towards their child’s education: whether they should contribute at all, how much they should contribute, or what should be their child’s responsibility. But if, as a parent, you have the resources to save, you should save something. Not at the expense of your retirement. You can borrow for college, but you cannot borrow for retirement. If you’re contributing to your retirement account, and you have 3-6 months of living expenses in an emergency fund, try to save something for a child’s education.
How much should you aim for? It helps to set a goal. Based on what you can afford and your own values, pick a percentage as your desired contribution goal.
Source: Responsible Dollars
If you have the advantage of saving early in the child’s life, you’ll get more benefit from earnings on what you’re saving.
Saving for College
So you’ve figured out that savings amount that aligns with your values. Now we need to figure out where you’re saving. You have a few options with different advantages and disadvantages.
The 529 Plan
This 529 plan is the most advantageous account for education savings. These accounts come in two flavors: 1) a prepaid tuition plan where you purchase credits at a qualifying school for attendance or 2) a savings plan where you invest on a tax-advantaged basis in a plan managed by a state.
In a prepaid tuition plan, you typically purchase credits at a participating public in-state university. These credits can be used for tuition and fees, but are not typically used for room and board. This plan allows you to lock in tuition rates at a certain level. You may need to be a resident to use your state’s prepaid tuition plan. Also, your state’s plan may or may not guarantee the funds paid into the plan. If not guaranteed, you may risk the money you put into the plan if the state sponsor experiences a shortfall. If your child does not attend a participating college, you will receive a payout of the credits you paid in, but you may only get a small return on your investment.
In a 529 education savings plan, you can invest in a tax-advantaged savings account for your child’s qualified education expenses, including room and board. In 2019, you can contribute up to $15,000 each year if you’re single ($30,000 if you’re married). Or, if you’ve had a large windfall, you can contribute a lump sum amount worth five years of contributions. That’s $75,000 if you’re single or $150,000 if you’re married.
Contributions to a 529 savings plan are made after after-tax. Earnings grow tax-deferred and are distributed tax-free if they’re used for qualified tuition and expenses. For post-secondary education, qualified expenses include tuition and fees, room and board, books and supplies, computers, and special needs equipment. It does NOT include transportation or travel costs, health insurance, application or testing fees, extracurricular activities, or student loans. As of the Tax Cuts & Jobs Act, you can even use up to $10,000 annually for tuition and fees for K-12 students. If funds are not used for qualified expenses, you may be subject to a 10% penalty and income taxes on the earnings.
529 education savings plans offer a variety of investment options and vehicles varied by state. Accounts may offer mutual funds, ETFs, and bank products. You can also select a static fund allocation or an age-adjusted portfolio that becomes more conservative as a child approaches college age. Savings plans vary by state. Investment options are pre-selected by the plan, and investors can make changes only twice a year. Although a few of the states have residency requirements to invest in their 529 savings plan, you can select a 529 savings plan administered by another state. You can view plans by state here.
Compared with the prepaid tuition plan, you can use a 529 savings plan for more expenses, and you have the opportunity to generate a return on your investments. However, you as the investor bear the risk of those investments, which may not perform well.
The concern many parents have with contributing to a 529 education savings plan is that their child either won’t attend college or they get a full scholarship. Opposite ends of the spectrum, but valid concerns. Let’s start with the first one: the kid doesn’t go to college. Well, every child’s journey is different. There is no requirement that you must withdraw the funds by a certain age, as opposed to the Coverdell ESA which requires distribution before age 30. If the child decides to attend vocational or trade school, they will still have qualified education expenses. If they do not pursue advanced education or vocational training at all, you can change beneficiaries to another child or qualifying relative, or you can keep the fund for a grandchild. If none of these applies, you can liquidate the account. Your contribution amounts are not subject to income tax (you already paid taxes on that income), but you will pay income tax on the earnings plus a 10% penalty.
Let’s jump over to the second scenario, in which your child gets a full scholarship and all of your savings were in vain. Not so fast. Some scholarships may not cover all qualified expenses, like books or supplies, or room and board. Your 529 savings can still come in handy. You can also use a 529 to pay for graduate school. Or you can change beneficiaries. If you distribute the account in this scenario, contributions are not subject to income tax. You still have to pay income taxes on the earnings, but your 10% penalty is waived.
There are many options for saving for college in a 529 plan. They are attractive because of their tax advantages while saving and paying for qualified expenses. You have investment choices that vary by plan, or you can simply pre-pay tuition expenses with a prepaid tuition plan. Due to the tax-advantaged nature of the account, the high contribution limit, and the breadth of qualified expenses in savings plans, the 529 is the go-to education savings account.
The Coverdell ESA
Before the Tax Cuts & Jobs Act, the primary advantage of this account was the ability to pay for K-12 expenses with tax-free earnings. Now, the Coverdell’s advantage is the ability to pay for qualified primary and secondary education expenses beyond the $10,000 tuition limit with the 529 plan. You can use this account to pay for supplies, equipment, tutoring, special needs, room and board, uniforms, transportation, and extended day services for primary and secondary education.
Compared with the 529 plan, the Coverdell ESA has a lower contribution. You can contribute $2,000 per year until the child turns 18. You must withdraw the funds by the time the child is 30, or you can change beneficiaries or roll over the account to a 529 plan. The Coverdell ESA still has a place, it’s just more advantageous for qualified primary and secondary education. Between the contribution limit and the age requirement in the Coverdell ESA, the 529 plan is superior for saving for college.
Due to concern around over-funding a 529 savings plan, some parents choose to allocate some or all of their education savings to a Roth IRA. The concern with over-funding a 529 savings plan is that the excess earnings, when used for non-qualified expenses, will be subject to income taxes and a 10% penalty.
By saving for education in a Roth IRA, parents can reallocate any excess savings the student doesn’t use toward the parents’ retirement. Similar to a 529 savings plan, contributions to a Roth IRA are made after-tax. Earnings grow tax-deferred and are potentially distributed tax-free in certain situations. Contributions are always distributed tax-free (again, you already paid tax when you made the contribution). However, if you take a distribution before age 59 1/2, your earnings will be subject to income tax plus a 10% penalty.
But education is considered a qualified distribution. If you use a Roth IRA to pay for qualified education expenses, the 10% penalty is waived, but you still must pay income taxes on the earnings.
In order contribute to a Roth IRA, your income must be below a certain income threshold. In 2019, if you make less than $122,000 per year as a single person or $193,000 per year as a married couple filing jointly, you can contribute $6,000 per year, plus an additional $1,000 annually if you’re over age 50. You are eligible for a partial contribution if you make less than $137,000 (single) or $203,000 (married filing jointly).
You may have more investment choices with a Roth IRA than with a 529 savings plan, but this could add complexity if you need to align your Roth IRA investments with a 529 savings plan.
To sum up, we walked through with some of the strategies with saving for college. We looked at the rising cost of college education, savings required to meet different contribution goals, and available savings vehicles commonly used for college planning. Exploring tax-advantaged plans, planning early, and saving what you can all contribute to a plan to help statistically improve the lives of your children.