A Q&A Guide to Saving for Your Child’s Education
Updated: Sep 12, 2019
Almost immediately after welcoming a newborn baby to the world, most parents start thinking about how they will pay for the child’s college education. In this article, we provide practical answers to common questions about when to start saving, how much to save, the types of accounts you can use, and the recent ability, in some states, to use 529 Plans for K-12 tuition.
Q. How much will it cost?
A. Brace yourself – the average cost of a four-year degree, assuming your child graduates in four years, is $130,000 for in-state universities, and $235,000 for private institutions. And that’s the cost today; it could easily double in over the next 15 years if prices continue to increase.
To alleviate the panic you may be feeling, keep in mind that while your family may not qualify for federal need-based financial aid. There are many scholarships and other forms of tuition assistance, particularly from private universities. Still, you can’t control the level of academic achievement, artistic talent, or athletic ability your kids will have, so the best approach is to control what you can – your savings.
Q. How can we save enough to reach that goal?
A. It helps to translate that four-year cost into an amount you should put aside monthly to cover most of it by the time the first tuition bill arrives. If your situation simply does not permit you to save that much, at least not now, you’ll be able to develop a realistic budget for what you can do and can try to increase your monthly savings over time. An important part of choosing a college, when that time comes, is knowing what your family can afford.
Gold Medal Waters’ financial planning financial planning software can with this calculation. You can specify where you think a child might end up going to college (and maybe graduate school), the child’s birthdate and how much of the cost you plan to cover. Many parents want their child to have “skin in the game” and do not intend to pay 100% of the cost, whether for a state school or an expensive private university, even if they are financially able to do so.
Of course, the amount you need to save each month depends heavily on the number of years before your child heads off to college – start now if you haven’t already. What better present for a baby’s first birthday than a nice contribution to a college savings account!
Q. What kind of account should we use for college savings?
A. The most popular approach to saving for college is through a 529 Savings Plan (not to be confused with prepaid tuition plans, which are declining in popularity for various reasons). 529 Plans are established by each state, but you do not have to use your state’s Plan – someone who lives in California can use the 529 Plan in Colorado, and so on. Some states give residents a tax deduction for contributions made to their home state’s Plan, so that may be an important factor in your decision.
There are no annual limits on 529 Plan contributions, except that amounts over $15,000 per year are subject to federal gift taxes. The total balance in a 529 account cannot exceed a limit that varies by state, currently ranging from $235,000 to $529,000. If your state has a low limit and you think your child may pursue a Masters degree, a Ph.D. or med school, you might want to choose a state whose Plan has a higher lifetime limit or open a second plan in another state.
The money invested in a 529 Plan grows tax-free, and no taxes are paid when you make withdrawals, as long as the money is used to pay for qualified educational expenses – that includes tuition, room and board and certain other costs.
Q. What if we save too much and our child doesn’t need it all? Or, what if he or she doesn’t go to college? Or gets a scholarship?
A. If your child does not need all of the money in the 529 Plan, you can transfer (rollover) the rest to another beneficiary – that could be a sibling, a niece or nephew, or even yourself. There are rules about how to do this to avoid triggering taxes and penalties (otherwise, you would have to pay taxes on investment returns plus a penalty, typically 10%), so seek professional advice before proceeding. If your child receives a scholarship, congratulations, that’s great! You can withdraw the amount of the scholarship from the 529 Plan with no penalty, although you will owe taxes on the investment gains. Get advice to make sure you have proper documentation and follow the rules.
Q. Is it possible to withdraw money in a 529 account for some other purpose?
A. There is a common misperception that money saved in a 529 Plan is “untouchable”, even if there is an emergency or you simply change your mind. While we do recommend viewing the 529 Plan savings as money you have dedicated to your child’s future and we do not encourage parents to use those funds if it can be avoided, it is possible to withdraw the money at any time. You would simply have to pay taxes and a 10% penalty, but only on the investment growth. Unsurprisingly, you would have to repay any tax breaks provided by your state and it’s perfectly legal to do so.
Q. How do we set up a 529 Plan?
A. You can go directly to the entity that administers the Plan in your state, or you can work with an advisor who can compare Plans from various states. Direct-sold 529 plans usually have lower investment fees than advisor-sold ones, but advisor-sold plans tend to offer more investment options. Some states allow self-directed investing in their 529 Plans, with great funds from firms like Dimensional Fund Advisors and Vanguard. You can have more than one account per child, but make sure each child has his/her own account(s). Don’t use one account to cover all of your children.
Q. Grandparents want to contribute. Should they use the account we set up or a different one?
A. Contributions to a 529 Plan can be a great estate planning strategy for grandparents. The contributions reduce the size of their estate, help their children (the parents) and grandchildren, and communicate their values. If the grandparents live in a state that offers a deduction for 529 Plan contributions, they might want to take advantage of that deduction for their own taxes. If not, they can definitely contribute to the account you set up.
Q. Is a 529 Plan the only option?
A. Some people decide to use their taxable accounts to save for college, even though they have to pay taxes on the investment returns every year. Some parents feel it is important to preserve liquidity and flexibility. Even though they can legally withdraw money from a 529 Plan for non-qualified purposes (as discussed earlier), they would feel “guilty” if they did so. That’s based more on emotion than reality, but it’s a personal decision.
Q. I’ve heard that money in a 529 Plan can now be used to pay tuition for K-12 private schools.
A. The tax reform act implemented in 2018 does allow this. However, as with other 529 Plan features, tax benefits are state-specific. Some states allow tax deductions for 529 Plan contributions used for college but do not allow a deduction for money used for K-12. Using 529 Plan funds to pay for K-12 is obviously not optimal from the standpoint of maximizing the benefit of compounding returns over time. Still, if your state allows you to deduct contributions to a 529 Plan from taxable income, you may want to take advantage of it. If you plan to pursue this option, we recommend having separate 529 accounts for K-12 versus college. A financial advisor can quantify the benefits and explain the restrictions.
Q. What should come first, saving for our kids' college or saving for our retirement?
A. This is a very important question. As parents, our instinct is to say “there’s nothing more important to me than my child and his/her education, even if that means I have to cut back on my retirement.” We understand – we’re parents, too. But that instinct is misguided. You can borrow for college education, if necessary, but you can’t borrow to pay for retirement. If your child needs to borrow to help pay for college, he or she would have a lot more time to pay back those loans than you would have to replace the lost retirement savings used to help pay for college.
Talking with a financial advisor can be a great resource in determining what is best for your situation. Saving for college is not just a matter of throwing as much money as you can into a 529 Plan with low fees or investment options you like. For the best result, approach this in the context of an overall financial plan that encompasses all of your goals.
Gold Medal Waters is a fee only financial planner located in Boulder, Colorado that specializes in serving the unique needs of physicians and high net worth clients. Coordinating a great financial plan isn’t easy. Learn more about what sets us apart, or talk to an advisor and get a free meeting to see if we are the right firm for you.