What Is The Best Way To Save For College?
- Save often.
- Start early.
- Earn good returns on your savings.
- Take advantage of any tax saving strategies that may be available.
The costs of attending college continue to rise. Tuition, room, meals, books, travel and other incidentals really add up. The total cost of attending many private colleges is over $50,000 per year and state universities can run over $25,000. Tuition rates have been rising faster than inflation. Many students are taking more than four years to get their undergraduate degree and others are going on to graduate school.
The advantages of starting early and saving often are obvious. The more you save, the more you will accumulate. The earlier you start, the longer the funds will have to grow.
Consider the benefits of starting early. Let us assume you want to save for a public university for a child that is now seven years old. By the time the child is ready for college, you need to have accumulated about $184,000. That reflects an expected increase in college costs of about 6% per year. If you start now, you need to save almost $16,500 per year. If you wait until the child is ten years old, your annual savings need to be about $19,600. If you had started when the child was three, you would only have needed to save $14,600 each year. These numbers assume you earn 3% on the funds.
If you earn 6% on your funds, the needed annual savings are:
Starting at age three – $14,300
Starting at age seven – $16,200
Starting at age eleven – $21,100
Starting early and saving often makes a difference and makes it easier to save more.
Ways to Save for College
Traditionally, parents or grandparents used a Uniform Gifts to Minors (UGMA) or Uniform Transfers to Minors (UTMA) type of account to save for college. Funds were transferred into the account and invested. The income from the account was taxable to the child at the child’s lower tax rates. However, several years ago, a “Kiddie Tax” was instituted which resulted in unearned income of children being taxed at the parent’s tax rate. These special tax rules now apply to children under the age of 18; 18 year olds with earned income less than half of their support and 19 to 23 year old students with earned income less than half of their support.
The Tax Cuts and Jobs Act of 2017 made substantial changes to the Kiddie tax and you may want to consult your tax advisor to understand how the new rules may apply to your child.
A few years ago, Coverdell Education Savings Accounts (Education IRAs) and Qualified Tuition Plans (Section 529 Plans) were created under the tax law to encourage saving for college. The 2001 Tax Law enhanced these programs.
Coverdell Education Savings Accounts allow for the annual contribution of up to $2,000, but there are parental income level limits that may restrict their use. Earnings on the funds within these plans are tax deferred and distributions are now tax-free if used for qualified education expenses. The accounts can be established at most financial institutions and usually provide considerable investment flexibility.
Section 529 Plans are programs established by states that allow for much larger contributions (generally up to $15,000 for 2021) and there are no income limits. The earnings on the funds are tax-deferred and distributions can be tax-free if used for qualified higher education expenses. The largest negative to Section 529 Plans is that there is usually less investment flexibility. If this type of plan seems attractive, investigate several states’ plans because there is no requirement to choose your state or the state where the child ultimately attends college.
As always, you should consult your tax advisor to learn how the tax laws apply to your specific situation.