If you have kids, or are planning to have them, saving for college is likely on your financial priority list. So are a lot of other things that seem more immediate, like saving for a house, or for home repairs. Paying for a car. Feeding and clothing the kids so they make it as far as college.
With college costs rising an average of 4% annually, pre-pandemic, the cost may seem overwhelming, too.
Parents already saving may wonder if they’re doing it the right way and getting the best return or if having savings will have a negative effect on financial aid.
Saving for college is hard, but not insurmountable, no matter what your financial situation. Doing it now will help ensure your child isn’t buried under a pile of student loan debt once they graduate. The sooner you begin, the less money you will have to save each month and the higher the return you will earn. It’s also important to make sure you are saving for retirement and have other priorities covered.
Many factors go into which is the best way to save for college and how much a month you should save.
When to Start Saving for College
The ideal answer to the question “When is the best time to start saving for college?” is NOW!
For some people that may not be possible. That’s particularly true for people who are in debt, haven’t set up retirement savings or don’t have an emergency fund. Those three things should be higher priorities.
Don’t panic if you aren’t able to start saving for college early. There are still options if you get a “late start.”
Financial experts recommend that the later you start, the more important it is to weigh tax implications. Savings methods with tax benefits can help cut the cost. There are a variety of methods that won’t mean a tax hit, include 529 plans, Coverdell educational savings accounts, savings bonds; custodial accounts and more.
We’ll look at them all in depth, but first, it’s important to know how much college will cost you and your future college student.
How Much to Save for College
A Sallie Mae study in 2019 found that more than half of parents are saving for their children’s college tuitions, but that the average savings will result in less than a year’s tuition when the child is ready for college.
The average cost in the U.S. for in-state state college tuition for the 2020-21 school year was $9,687; average cost for a private college was $35,087, with out-of-state tuition for public colleges falling about in the middle. That’s a slight drop from the previous decade, when college costs steadily increased 4%-5% a year, but the decrease is largely because of the coronavirus pandemic, and it’s expected to start ticking back up in coming years. Financial experts advise clients calculating how much they’ll need to save to expect the sticker price – tuition, room and board, and fees — to rise by 5% a year.
The averages are just that — averages. The top 50 most expensive colleges in the U.S. in 2020 had sticker prices above $74,000, with the most expensive the University of Chicago, which costs $85,531 a year to attend. Many of these top colleges also offer extensive financial aid, including need- and merit-based scholarships, that can cut the cost considerably. But no matter what the cost of the school, getting financial aid is less a sure thing than having money saved in the first place.
The aim is to pay for as much of college as possible at the time the student attends, rather than face student loans after graduation that will be a burden for years. The average student loan debt in the U.S. for those graduating in 2019 was $32,731, with an average payment of $393 a month. Overall, 44.7 million borrowers owe about $1.6 trillion in student loan bills.
Student loan debt can have long-term negative financial effects on the borrower. A 2019 Maine study found that college graduates with loan debt had trouble buying a home, a car, or even paying for prescriptions and other necessities.
How much should be saved for college depends on factors that include when you start saving, what type of account you use and the school you expect your child to attend.
Most experts say, in general, to aim for saving a third to a quarter of what you expect to pay overall, and hope to recoup the rest with student loans, grants, scholarships and other means. Of course, there’s nothing wrong with the student also working on the problem. They can make and save money, while achieving academically.
Experts also say not to worry that savings targeted for college will cut into financial aid, and therefore be pointless. Most education savings programs are set up so that they enhance payment options, not make them more difficult.
How to Save for College
There are almost as many types of accounts to help save for college as there are types of colleges to save for. Which account is best depends largely on a saver’s financial situation, how much they want to save, and how much they’re able to save.
Here are some of the most common and effective ways to save for college.
Regular Savings Account
A good old-fashioned savings account at a bank or credit union will yield about 2% interest a year. Savings accounts are a safe and trusted way to save money. Banks are guaranteed by the Federal Deposit Insurance Corp. and credit unions are guaranteed by the National Credit Union Federation, so even if the institution fails, savings are protected.
The negatives of using a savings account to save for college is that it can count toward parent’s or student’s assets, which can lower the amount of financial aid a student is eligible for. The interest rate is also lower than with accounts geared specifically toward college savings.
There’s also the temptation factor – it’s easy to withdraw money, keeping the account from growing.
529 College Savings Plan
A 529 operates like a Roth IRA. It uses after-tax money that can only be withdrawn for specific education purposes for the student listed as a beneficiary. Most plans allow those besides the person who has set up the account to contribute.
While the details for 529 plans vary slightly from state-to-state, they are a solid way to save money for tuition, books, fees, supplies, and room and board, without having to pay taxes on earnings.
Pros of a 529 plan:
- If it’s used for the specified educational purposes, taxes aren’t paid on earnings.
- The money can be used at any accredited college – two-year, four-year, graduate, undergraduate.
- $10,000 per beneficiary can be used pre-college for private school costs, from kindergarten through high school.
- If the original beneficiary doesn’t use the money, the beneficiary can be changed.
- The money can be rolled into an ABLE account that covers expenses for disabled children and young adults.
- The cap varies by state, but must be at least $235,000, and is much higher in most states.
- The money invested can be used as a yearly tax deduction in 34 states.
- Anyone, not just a parent, can open an account for a child’s education.
- Only a fraction of a parent’s account counts against financial aid, and student-owned accounts don’t count at all against financial aid.
Cons of a 529 plan:
- Some states charge state income and capital gains taxes.
- There’s a 10% penalty, as well as income tax charged, on earnings if the withdrawn money isn’t used for qualified educational purposes.
- Investment options are restricted.
- Withdrawals from accounts owned by someone other than the student or parent have to be added back to the student’s income on the following year’s financial aid form and can reduce financial aid eligibility by as much as 50% of the amount of the distribution.
Education IRA or Education Savings Account (ESA)
Education Savings Accounts (ESA) and Education Savings IRAs allow a maximum investment of $2,000 per child a year, after taxes, for those whose income qualifies. The limit is reduced if a parent’s modified gross adjusted income is $95,000 (or $190,000 for those filing jointly). Those who make $110,000 a year ($220,000 filing jointly) are not eligible.
These accounts work especially well for those who start when the child is born, or very young. If the maximum is invested every year until the child goes to college, the amount invested will be $36,000, and the account will have earned more interest than a regular savings account. Withdrawals are tax-free.
Pros of Education IRAs and ESAs:
- The earnings are tax free.
- There are a wider range of eligible uses (such as tutoring and uniforms), than with 529 plans.
- It’s a relatively painless way to save money for college long-term.
Cons of Education IRAs and ESAs:
- Those who are above the income limit have a lower yearly cap, or are not eligible.
- Those who are below the income limit still can only contribute $2,000 a year.
- The amount must be used by the beneficiary by age 30.
Those who are already saving for retirement with a Roth IRA, may want to add in a little to save for college.
Like the 539 plan, money that taxes have already been paid on is invested into a Roth, and earnings are tax-free. If money is withdrawn before the owner is 59 and a half for education, there is no penalty, but the earnings are taxed.
Pros of using a Roth IRA:
- It’s flexible – the money doesn’t have to be used for college tuition if circumstances change.
- Earnings can be withdrawn penalty-free, though taxes still have to be paid, if the money is used for higher education for the account-holder, their children, or their grandchildren.
Cons of using a Roth IRA:
- Once the money is withdrawn, it counts against income and can reduce financial aid.
- Using the money for education can reduce retirement savings
- Other relatives or friends can’t contribute the way they can to a 529 plan.
UTMA or UGMA Custodial Accounts
Uniform Transfer to Minors Act (UTMA) and Uniform Gift to Minors Act (UGMA) accounts are pretty much what they sound like. Money is saved for the potential college student until he or she is 18 under UGMA and 21 under UTMA, then it goes to them. Once the student gets the money, there are no restrictions on how they spend it.
Both accounts hold cash, stocks, mutual funds and other assets, and UTMAs can also hold real estate.
Pros of UTMA/UGMA:
- There is no limit to how much money can be invested.
- Money can be used for anything, not just specified college expenses.
- There are tax benefits, including the value of the account being removed from the investor’s gross estate.
Cons of UTMA/UGMA:
- The beneficiary doesn’t have to use it for college
- The beneficiary can’t be changed once he or she is designated.
U.S. Savings Bonds
U.S. Savings Bonds are government bonds that are bought at 50% of their worth, then redeemed 15 to 30 years later for the full amount. The interest on bonds is free of state and local taxes, and federal taxes are deferred. With Series EE and I bonds bought after 1989, there are also no federal taxes if the money is being used for higher education expenses and the owner meets income requirements.
Pros of U.S. Savings Bonds:
- They’re tax-free if bought after 1989 and used for qualified higher education expenses.
- They’re secure, with a guarantee that the money will be there when they’re cashed in.
Cons of using U.S. Savings Bonds to save for college:
- The maximum investment is $10,000 a year, per owner and type of bond.
- If bond proceeds are not spent on tuition and fees, interest earned is taxed.
- Federal tax savings does not apply for those whose federal gross adjusted income is between $78,150 and $93,150, or $117,250 and $147,250 if filing jointly.
Invest in a Mutual Fund
Mutual funds are a good way to invest for long-term savings, and there is no limit to how much can be saved. With thousands of funds available, there are also a lot of options and chances for good return on investment. That said, they come with more cost than some education-specific savings plans do.
Pros of using mutual funds:
- The money is not restricted and can be spent wherever it’s needed.
- There’s no limit to how much can be invested, and no restrictions on when it can be withdrawn.
- There are more than 10,000 mutual funds available, so finding an option with a high return is good.
Cons of using mutual funds:
- Earnings are subject to annual income taxes.
- Capital gains are taxed when shares are sold.
- If owned by a parent, they’ll reduce financial aid eligibility by up to 5.64% of the account value, which grows to 20% if owned by the student.
Educational Trust Fun
A trust fund, similar to UMGA and UMTA, is an account that is set up by parents and then handed over the child when they reach a certain age. The person who sets up the trust determines what the money goes to and how it’s paid out, so it can be as specific or general as the parent wants it to be.
Pros of an education trust fund:
- There is more flexibility for using the money than with other education-specific funds.
- The person who set up the fund can transfer assets and minimize their estate taxes.
- There’s no limit to how high the fund may be.
Cons of using an education trust fund for college savings:
- The beneficiary may have to pay taxes on trust fund earnings.
- It can have an impact on how much financial aid the student is eligible for.
Get help from Friends & Family
Friend and family, particularly grandparents, in many cases want to help with saving for college. The 529 plan makes that easy, allowing anyone to contribute. Asking for contributions in lieu of birthday or holiday gifts is a great way to add to the fund. The 529 plans vary, but most of them have ways to accept gifts, and some retailers sell 529 gift cards, though those include a small fee.
People can also give in other ways, including many of the ways listed on this page, but it’s important, especially if they’re not the parent or guardian, to research the negatives as far as tax impact, and impact on financial aid.
How to Reduce the Cost of College
It’s not just up to parents to find a way to save for college – students, too, can take responsibility. In fact, more and more, parents are expecting it. According to a Sallie Mae study, 59% of parents in 2019 said the student should take some of the responsibility of saving for college, as opposed to 51% in 2016.
Students can earn money and earmark it to a college account, ask for monetary gifts for college savings for birthdays and holidays, and more. Students with financial need can qualify for Pell Grants, a federal program that provides grant money for school.
Taking Advanced Placement courses in high school will earn college credits, reducing the amount they have to pay once they go to college.
There are countless scholarships available for students, no matter what their financial situation. Students should start with their high school guidance departments, which are the best sources of local and national resources available. The internet also has many scholarship search tools. The best way to start is simple search “best college scholarships” online.
Washington Monthly publishes a yearly list of colleges that are the best financial option for students. The “Best Bang for the Buck” college guide measures not only financial aid trends at schools, but how well students do after they get out of college as far as salary, job prospects and debt.
Colleges within commuting distance, state schools and community colleges all offer quality education. Many community college systems also have bridge programs that provide short-term training so students can get skilled jobs, allowing them to work for decent pay while pursuing an associate degree. They are a way to earn a degree and get on a career path without piling up student debt.
Consider Getting Professional Help to Pay for College
No matter where you are on the college savings journey, making sure you’re in a financial position to save money for college is key. If you have credit card debt, you may want to consider credit counseling, which can help you create a budget to start putting money away for your child’s college education. A nonprofit credit counseling agency also could provide a debt management program, to reduce your debt and make saving easier.