The cost of college is undoubtedly one of the most widely debated issues. Deciding how to save and pay for college in the face of growing tuition is an important decision for millions of families.
Long before your kids start college, you can start preparing to pay those big bills with a 529 plan. Through these college savings programs, parents can invest toward their child’s education, and any earnings are tax free if used to pay for college costs.
If you have a newborn or a high school aged child at home, it is never too early or too late to think about paying for college.
The Current Student Debt Situation
Millennials are struggling to pay off their share of over $1.3 trillion in student debt. With so much student debt we have to consider: What do we want for our children? Should they have to suck it up and utilize student loans like we did? Or, should we cover the costs of school to allow them to save more for their future?
The average member of the class of 2016 graduated with $37,172 in student loans, an increase of 6% from the prior year. With tuition and student loan balances ballooning, we have to seriously consider the best way to save for our children.
College Savings Options
As the father of a eight-month-old girl and someone who paid off my own $40,000 in student loans, I am constantly thinking about how my family will afford the cost of college when my little girl applies to be a member of the class of 2038. If you use the average rate increase for the cost to attend college, she could potentially need more than $200,000 to cover the cost of a college degree.
If I put a little more than $11,000 per year in a savings account paying no interest, I will hit the $200,000 mark when she turns 18. But, for most investors, taking on a little risk with conservative investments may provide significant growth for long-term goals like college funding.
Assuming an earning of six percent per year, you would only have to put $6,150 into an investment account annually to reach a $200,000 balance in 18 years.* That is about half of what you’d need to save with a basic savings account.
It is clear that investing for college savings is a great option, but there are several routes you can take to save and invest for that potentially $200,000 milestone (per kid!) hanging over every new parent’s head. Here are some common options:
- Regular Savings Account – Virtually zero risk, but these accounts currently pay a lower interest rate than inflation.
- Taxable Investment Account – Unrestricted access to investment options and funds, but you have to pay capital gains tax or income tax for withdrawals.
- 529 Plan – Investment gains are not subject to capital gains tax and income taxes so long as funds are used for qualified education expenses. Otherwise, you pay federal and state taxes plus a 10 percent tax penalty.
Is the Stock Market a Safe Place for My Child’s Education Funds?
Before looking at the pros and cons of a 529 account, it is important to understand some basic risks of the stock market. The stock market has historically performed well over time, but the key to capturing that growth is leaving your investment alone in both good and bad years. Since its inception, the S&P 500 has yielded a compound annual growth rate of 10.47 percent.
But there are good years and bad years. In the heart of the Great Recession, the index lost 39.49 percent. In 2013, it grew by 29.60 percent.
If you have a long investment time horizon until you will need the money, leaving it in the stock market is generally considered a good idea. If you have fewer years until you will need the money, considering a more conservative investment, such as a government or corporate bond fund, lowers the potential risk and may increase stability.
There is never a guarantee of positive stock market returns, so use your best judgment when planning to pay for your kids to go to college. If you are uncomfortable doing this on your own, you can find a trusted, financial professional to pick the best plan for your needs.
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Pros of a 529 Account
A 529 plan offers the potential for significant tax advantages for parents stashing away money for a child’s education. Other family members can also contribute to the account, as well, if they’d like to get involved with helping your child save for college – that means grandparents, aunts, uncles and anyone else.
You also control the funds every step of the way so you never have to worry about your child raiding their 529 to pay for a big Spring Break vacation. You can use money from a 529 plan for tuition and fees, required textbooks, and housing. There are some nuances to using funds for room and board expenses, so make sure to do everything by the book.
As we already discussed, when investing in a stock market account, you do not have to save nearly as much as you would with a savings account. But there are tax implications, unless you have tax-free investment gains. Which brings us to the biggest benefit of a 529 account: the tax break.
With most investments, you have to pay capital gains and/or income taxes when you withdraw your funds. No one knows what the tax code will look like in the future, but the safest assumption is that capital gains taxes will be similar, and 529 plans will still offer the potential for tax-free investment growth.
Cons of a 529 Account
Every 529 has different investment options, and they are usually not as extensive as a regular brokerage account. In this respect, they work more like a 401(k), where you can choose between a limited set of options. You can change the investments in a 529 account once per year.
Here’s the biggest downside. Let’s say I want to save so that my child can attend any university in the country, including high priced Ivy League schools. Who knows, those could cost $500,000 by the time my baby goes to college. So what happens if I save up $500,000 in a 529 account with her name on it, and she doesn’t use some or all of it?
Unless you have more kids who need to pay for college, a fat tax bill is what happens, if you want to remove the excess funds. But, 529s allow you to change the beneficiary at any time. Without paying any taxes, you can change to the original beneficiary’s siblings, yourself, grandparents, first cousins, aunts, or uncles. However, the dollars still have to be used for college expenses or other qualified educational expenses to avoid that 10 percent tax penalty on your gains.
This is a big incentive to avoid over-saving in a 529 account.
Also, remember that the funds can only be used for one beneficiary at a time, and the beneficiary can only be changed once per year. If your kids may be in school at the same time (e.g. born within four years of each other), it is best to establish a 529 plan for each child.
If you do end up with a lump of money after your children finish school, you can go to a local community and take a few classes for your own enjoyment or send your spouse off for a master’s degree. Worst case, you withdraw the funds and pay taxes plus the 10 percent penalty.
Other Useful 529 Information
Every state has different rules for opening and managing a 529 plan., and you don’t necessarily have to invest through your own state’s 529 program. Some states take money from residents of any state, while others are only for current residents.
Think very long-term when choosing a 529 plan and deciding how much to invest. Some state’s 529 plans only allow the funds to be used for in-state universities, while others allow the funds to be used at any accredited college or university.
Some 529 plans for in-state schools allow you to pre-pay “credits” that can be used for higher education at a later date, which essentially allows you to lock in current tuition rates for future education. But again, remember that these plans only allow credits to be used at in-state public universities. In addition, some in-state plans offer state tax advantages. If you are sold on the benefits of a 529 and want help in picking the best plan for you, this post from finance blog The Simple Dollar goes over some details of each state’s 529 options.
Your Best Option Depends on Your Financial Situation
You can open a regular, taxable investment account today that you plan to use for their education with no strings attached and pay capital gains or income tax on earnings. Or you can go the 529 route and save for the future with the potential for tax free earnings. Just be careful to avoid over saving.
The best option is probably a combination of the two. Putting a conservative amount of college savings in a 529 plan will help you avoid the “over saving” conundrum, and you can supplement savings from a taxable account that you can access at any time and for any reason. Maybe you’ll even help pay for that big Spring Break trip down the road.
There is one thing we all know for certain. College is expensive and the cost keeps going up. It is never too early to prepare, so put together a college savings plan for your children. When their friends are stuck paying off big student loans, they will be saving for their own future, and might even start a 529 for your grandkids with the money they save.
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Eric Rosenberg is a finance, travel, and technology writer originally from Denver, Colorado living in Ventura, California. When away from the keyboard, he enjoys exploring the world, flying small airplanes, discovering new craft beers, and spending time with his wife and baby girl. You can connect with him at his own finance blog Personal Profitability.
*This is a hypothetical example. It doesn’t reflect any specific investment and doesn’t account for any investing fees or taxes that might apply.