I’m often asked, “When’s the best time to start saving and planning for college?”
My answer is, “The day your kids were born. And the second best day is today.”
Without a doubt, the best way to pay for college is to save and invest for it ASAP because the more you save now, the less you’ll have to borrow later.
The only thing worse than having to pay the high cost of college is having to pay with loans and adding interest to the cost.
Here’s some quick back-of-the-napkin math.
If you save and invest $500 per month for 20 years, you’ll have invested $120,000 of your money. With an 8.05% return on that invested money, the $120k will grow to $285,000.
If you don’t save and invest and have to borrow $120,000 at 8.05%, which is the current (2024) interest rate for a Direct Parent PLUS Loan, on a 20 year repayment plan you will spend $240,000.
That’s a combined loss of $285,000 ($165,000 in investment growth opportunity cost losses plus $120,000 in additional interest paid).
So if you’re thinking about starting to save and invest for college, follow Nike’s maxim: “Just Do It.”
But HOW?
There are a number of ways you can save and invest for college. Here are some options, and their pros/cons.
- Coverdell Education Savings Account (ESA): This ESA allows you to save for educational expenses with tax-free earnings growth, which is good. However, contributions are limited to $2,000 per year per beneficiary, and there are some relatively low income restrictions based on your Modified Adjusted Gross Income (MAGI). So, these are okay, but not great.
- Custodial Accounts (UGMA/UTMA): These are trust accounts that allow you to save and invest on behalf of a minor. Once the child reaches adulthood (usually 18 or 21, depending on the state), the “child” gains control of the account and can use the funds for any purpose, including college. They can also blow it on slot machines in Vegas, which is why Kyle and I don’t recommend these. Giving 18-21 year olds unrestricted access to a pile of money is probably a bad idea. We know because we were 18-21 once (thankfully before cell phones with cameras).
- Roth IRA: While Roth IRAs are typically used for retirement savings, they can also be used for college savings because contributions to a Roth IRA can be withdrawn penalty-free for qualified education expenses. However, we don’t recommend this as a primary strategy because the high cost of college creates the risk that you’ll drain too much from the IRA and be broke in retirement.
- Savings Accounts: Traditional savings accounts can be used for college. However, you likely won’t get much in the way of investment returns. And, if it’s a custodial account in the child’s name, it will artificially inflate your Student Aid Index (SAI) later, and therefore potentially increase the net price you’ll have to pay. (NOTE: the SAI drives how the net price you pay for college. If you don’t know your SAI, you need to – asap. Use the free College Money Report tool on our college planning page to calculate your SAI and see how it affects net prices).
- Brokerage Accounts: Brokerage accounts are, in my option, an underutilized college planning tool. The funds inside a brokerage account can be used for any purpose without penalties. If your child goes full Animal House and flunks out (or more optimistically, receives a big scholarship) and you don’t need the money for college, you can use the funds for other financial goals like retirement or buying a boat. The main drawback is that brokerage accounts are taxable, but keep in mind that long-term capital gains are taxed at a lower rate than ordinary income. So, these are an option to consider as part of your overall financial plan.
In my opinion, though, the champion of the college savings vehicle is…the 529 plan.
Here’s why.
The 529 Plan
A 529 plan is an education savings account that’s named after Section 529 of the Internal Revenue Code. These plans are typically sponsored by states, state agencies, or educational institutions, and they’re designed to incentivize saving and investing for education.
There are two main types of 529 plans:
- College Savings Plan: This plan is like a Roth IRA for education. You contribute after-tax money into the account, which is then invested in various options such as mutual funds. The funds then can be used later for qualified education expenses at any eligible educational institution.
- Prepaid Tuition Plan: These plans allow you to purchase credits or units at participating colleges and universities for future tuition and, in some cases, room and board. These credits typically cover a predetermined amount of tuition, regardless of future tuition increases.
The reason I like 529 plans (though, again, other options like brokerage accounts are definitely worth considering), is that they provide a number of great benefits.
Here are the Top 5.
- Tax Benefits: Contributions to a 529 plan are made with after-tax dollars, but the earnings grow tax-deferred, and withdrawals for qualified education expenses are tax-free at the federal level. In addition, many states (not all) offer state tax credits for contributions. We at Leetown Advisors HATE taxes because it’s the silent wealth killer, which is why we focus so much on reducing our clients’ tax burdens.
- Flexibility: 529 plans can be used to cover a wide range of education expenses, including tuition, room and board (including off-campus housing), books, and even certain technology expenses. In addition, you can transfer beneficiaries, if needed. For example, if your oldest child doesn’t use all of their funds, you can transfer the money for a younger child’s college. And new rules allow you to rollover unused 529 funds into a Roth IRA for the student or use the funds to pay off student loans. There are rules around this, however, so consult a fiduciary financial planner who specializes in college planning for help.
- Investment Options: 529 plans typically offer a range of investment options, allowing you to choose a portfolio that matches your time horizon, risk tolerance, and investment goals. One simple and effective investment strategy is using age-based mutual funds. These automatically rebalance the investments inside the mutual funds to reduce market exposure as the child nears high school graduation. This makes investing for college relatively simple and low-cost.
- Estate Planning Benefits: Contributions to a 529 plan may help reduce the taxable estate of the account owner, particularly for larger contributions. Contributions to a 529 plan are considered gifts for tax purposes, but you can contribute up to the annual gift tax exclusion amount ($15,000 per individual in 2024) without incurring gift tax consequences. Additionally, you can “superfund” a 529 plan, which means making a lump sum contribution of up to five times the annual exclusion amount without gift tax consequences, provided you don’t make any additional gifts to the same beneficiary over the next five years.
- Minimal Impact on Financial Aid: While 529 plan assets are considered when calculating financial aid eligibility, they are typically treated favorably compared to other assets, such as savings accounts or investments in the student’s name. This means that having funds in a 529 plan may have a relatively smaller impact on financial aid eligibility. And, importantly, if the owner of a 529 plan is a grandparent, there is ZERO impact on the Student Aid Index (again, if you don’t know your SAI, get it here). This, combined with #4 creates a wonderful multi-generational planning opportunity.
In conclusion, saving and investing for college is much better than borrowing for it. And if you’re going to save and invest, consider all of your options, but keep 529 plans high on your list. If you’d like to learn more, visit our website or schedule a consultation!
*The content contained herein is intended as education and entertainment, and does not constitute investment, tax, or legal advice. Please consult the relevant advisor before making any decisions. Additionally, any opinions expressed here are solely those of the author, and do not represent the opinion of Leetown Advisors or its affiliates.
