College costs in the United States have skyrocketed in the last 25 years. In Ohio, where I live, the in‐state cost for one year of college at a public university is currently $20‐25,000 for tuition, room, board, and other expenses. With the cost of college rising more quickly than the general rate of inflation, it is clear that planning and saving for college costs must begin as soon as possible. Assuming a 5% college inflation rate, today’s $100,000 college bill will be over $240,000 by the time you drop off your newborn for Freshman Orientation.
The daunting task of how to save for college is made more manageable by better defining the scope of the problem now. With a moving target that is ~18 years it is important to think in generalities because the specifics will most likely change. I like to use a simple three question approach. The three questions are:
- Which college will you or your child be attending? In other words, how much is the savings goal?
- What investment vehicle will take you there?
- How much fuel do you put in the tank? How much can you invest on a routine basis?
How much is the goal?
In determining the amount to save, the first question to discuss is what type of college do you envision your child attending? Public or private? In state or out‐of‐state? It may seem crazy to be thinking this way for a newborn or a toddler, but if don’t have a goal then you are really just hoping and not really planning. You want to make sure that you end up in the right ballpark. Pick a school, pick a number and get started! Your understanding of future costs will become clearer as the time shortens so it is important to review the plan every year or two to ensure you are on track and to adjust if the goal or your available resources have changed.
I find that most parents decide to plan for an in‐state public school. So let’s say, for planning purposes, you think Junior is going to attend a public college which currently costs $100,000 for 4 years. This amount can be refined by asking yourself what portion of this amount will we, the parents, pay for, and for how much will we make Junior responsible. I find that many parents want their child to have some “skin in the game” in order to better appreciate the value of their education. I like to use a simple flow chart (shown to the right) to work through the logic of a college funding plan. You can work the flow chart from left to right or right to left. You will probably also want to re-work through a couple times as you refine the plan. I also find it useful to initially keep everything in current costs, and eventually translate these to expected future costs using your expected college inflation rate. An online calculator or your financial advisor can assist to converting current costs to expected future costs.
Without going to into too much detail, your child will have three ways to pay for college—out of his/her own pocket (a.k.a., a job), borrowing money, or earning free money through scholarships. If you are planning for an infant, you may want to stop at estimating Junior’s total share of the cost and iron out the details closer to college. As the parents, you will also have three ways to pay for college—out of your own pocket (your job); parent loans; and the investments you set up for that purpose. Keep in mind that you will most likely stop your monthly college investing when Junior starts college—it makes no sense to invest into an account from which you are regularly making withdrawals.
Which investment vehicle to use?
One of the most important things to do is to get started because time is indeed money when it comes to investing. I have seen too many parents, however, get bogged down in the decision of what to invest in because of the many choices and sometimes conflicting information from financial media and “helpful” family members. I have also seen zealous parents invest in something recommended by a friendly neighbor, trusty coworker, or dad that turns out to not to really meet the needs of their bigger financial picture. To get a general idea of how your various college investment options compare to each other, I find it is useful to consider a “spectrum” of choices which range from maximum tax advantage to maximum flexibility. In general, as you gain tax advantage you give up flexibility on how you can spend the money. The four options are 529 Plans, Educational Savings Accounts (ESA), custodial accounts such as UGMAs or UTMAs, or your own parental investment accounts. A non-exhaustive description of the 4 options follows…
529 Plans. 529s are popular option for college savings. Most 529s are state sponsored plans which may offer a tax advantage on your state taxes. The exact contribution limit varies by plan but is usually about $250,000 over the life of the child. (I’ve never had a client hit this limit.) The funds grow tax free and are withdrawn tax-free if used for a qualified expense at a qualified college or university. The flexibility issue is that the money must be used for college.
ESAs. ESAs (sometimes referred to as Coverdell Educational IRAs) currently allow a maximum annual contribution of $2000 per child. Like a 529, an ESA is also tax free as long as it is used for education. While you lose the state income tax advantage, you gain the flexibility of using the funds for any educational expense (except home schooling) not just college.
Custodial Accounts: UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) accounts are more or less the same thing and, strictly speaking, are not “educational accounts” although that is what most people use them for. With a UGMA/UTMA you are giving the money to your child while remaining on the account as a custodian. As such, the funds can be used for any purpose which benefits the child. You may invest an unlimited amount into a UGMA or UTMA although you should be cognizant of gift tax limitations. Funds not used for education must be fully transferred to your child at adulthood. The funds are also taxable to your child so you will want to consult with your tax advisor to understand the specific impact of that.
Parental Accounts: Finally, you have the option to increase your own investment accounts to fund college for your child. This choice obviously gives you total flexibility on spending the money.
One last thought on investment choices…you are not constrained to choose only one investment vehicle. Many parents opt, for example, to use an ESA or 529 to get some tax free growth but combine it with a UGMA or increase in their own accounts to give themselves the flexibility to divert the money to other goals.
How much fuel to put in the tank?
Finally, you must decide where the money will come from to fund the educational plan. You must prioritize your desire to fund college versus funding your other long-term goals such as retirement or a future home purchase. You will need to have a very good handle on you budget to identify monthly dollars that can go to the college account. And you may need to circle back to our first funding flowchart if it seems that adequate funding dollars are not currently available.
The most important thing is to get started doing something. The longer you wait to get started, the bigger the problem becomes. You may have the resources to be able to fully fund Junior’s college education. You might not. Regardless, you will feel better knowing that you did you best.