How to Save for College

November 11, 2019

College is expensive. Parents pay for college using a combination of college savings, contributions from income, scholarships, grants, tax credits, student employment and student loans. Increasing the amount of college savings can make college more affordable and reduce the amount of student loan debt. But, how do you get started saving for college? What is the best way to save for college? This introduction to college savings will help you get the answers you need to your questions about saving for college.

Why Save for College?

Before we get to the “how” of saving for college, we should discuss the “why.”

College is a worthwhile investment in your child’s future. Not only do college graduates get good jobs, earn more money and have lower unemployment rates, but they are happier and healthier than people with just a high school diploma.

Saving for college provides the family with financial advantages when paying for college. Families who don’t save for college may qualify for slightly more financial aid, but the families who save for college have more money overall to pay for college.

Let’s consider one of the most common myths about saving for college, that you’ll miss out on financial aid if you save for college. It is true that your child’s financial aid package will be slightly reduced, but the impact is minimal and the college savings is still worthwhile. For example, if you save $10,000 for college the right way, eligibility for need-based financial aid will be reduced by at most $564. That still leaves you with $9,436 more to pay for college costs.

There are several other reasons why parents should save for their children’s college education. College savings are the antidote to student loan debt. College savings can reduce or eliminate student loan debt.

College savings also make college more affordable. College savings provide flexibility in college choice, allowing the student to choose a college that is more expensive than the family could otherwise afford.

Contributing to a grandchild’s college savings plan is also a good way for grandparents to leave a legacy for their grandchildren. College savings are also a great way for friends and family to invest in a child’s future.

How Much Do I Need to Save for College?

Every dollar you save is a dollar less you’ll have to borrow. So, by saving more for college, you reduce the student’s (and parent’s) debt at graduation.

You could save the full cost of a college education. But, if you try to do that, you’ll likely get sticker shock when you figure out how much college will cost 17 years from now. College might cost then as much as 2 to 3 times as much as it does today.

Take a breath. Realize that you don’t have to save the full cost of a college education. Instead, part of the cost will come from income and financial aid, and part of the cost will come from a reasonable amount of student loan debt. You don’t have to get rid of all student loan debt to make a positive impact – just enough to make it possible for your child to afford their student loan bills every month.

Figure on a third of college costs coming from past income (savings), a third from current income and financial aid and a third from future income (loans).

Thus, you should aim to save about a third of college costs instead of the full amount. But again, every dollar saved is a good thing, even if you won’t be able to save all that much.

How Often and How Much Should I Contribute to College Savings?

It helps if you break down the college costs into baby steps, such as the amount you’ll need to save per day or per month.

For example, saving a dollar a day starting at birth will yield $10,000 by the time your child enrolls in college. Spare change can really add up.

Saving $250 a month will be enough to cover a third of the cost of sending a baby born today to an in-state 4-year public college. That’s a bit less than what the average family spends per month on eating out at restaurants. Save $450 a month for an out-of-state 4-year public college and $550 a month for a private 4-year college.

But, even if you can’t save that much, save what you can. Everything you save will save you money. It’s also easier to increase the amount you save after you get started.

In addition to contributing monthly to a child’s college savings, you should also consider giving the gift of college instead of toys and other presents on birthdays and holidays. When your family and friends ask for gift ideas, suggest Gift of College gift cards. After all, the child is more likely to play in the box the toy came in than with the toy itself. So, just give them a box to play in and contribute the rest to college savings.

You can also find creative ways to boost your child’s college savings. Use credit cards that offer cash back rewards and put all of that money towards student loans. Sign-up for Upromise so that anytime you shop, dine out or book travel, a percentage of your purchase goes towards college savings. Anytime your child receives cash as a gift, put it towards their college fund. Since kids seem to go through clothes and toys at the speed of light, sell those items that they aren’t using any more to apply towards the savings.

When Should I Start Saving for College?

Ideally, you should start saving for college soon after the child is more than just a twinkle in your eye.

Time is your greatest asset. The sooner you start saving for a child’s education, the more time there’ll be for your earnings to compound.

For example, if you start saving for college from birth, about a third of your college savings goal will come from earnings. But, if you want until your children enter high school, less than 10% of the savings goal will come from earnings, and you’ll have to save six times as much per month to reach the same college savings goal.

Of course, you should get the rest of your financial affairs in order first. This includes paying off any high-interest debt, setting up an emergency fund with half a year’s salary and maximizing the employer match on your 401(k) retirement plan.

What Type of Account is Best for College Savings?

There are several types of accounts that one can use to save for college, including

529 college savings plans
prepaid tuition plans
Coverdell education savings accounts
custodial (UTMA or UGMA) bank or brokerage accounts
bank CDs
U.S. Savings Bonds
Roth IRAs

529 College Savings Plans: 529 plans provide the best combination of tax and financial aid advantages. A savings account might be a good temporary place to park the money until you’ve had a chance to open a 529 plan account, but it is best to save the money in a 529 plan long-term.

Prepaid Tuition Plans: Prepaid tuition plans provide peace of mind, but are not as useful for students who go to college out of state. Many prepaid tuition plans suffer from actuarial shortfalls, meaning that the prepaid tuition plan might not be able to satisfy all future obligations.

Coverdell Education Savings Accounts: Coverdell ESAs provide more control over the investment choices and allows the savings to be used to pay for K-12 expenses, but are otherwise much more limited than a 529 plan.

Savings Bonds: Series EE Savings Bonds (since 1990) and Series I Savings Bonds provide tax-free interest when the savings bond proceeds are used to pay for higher education or rolled over into a 529 plan, but the income phaseouts are somewhat low.

Roth IRA: A Roth IRA might be a worthwhile route if there is significant doubt whether the child will go to college.

How Should I Set Up a 529 Plan?

Most families should open a direct-sold 529 plan, as opposed to an advisor-sold 529 plan. Direct-sold 529 plans charge lower fees.

You can invest in any state’s 529 plan and use the money to pay for college in any state. So, you are not locked in to your state of residence.

Focus on 529 plans that have total fees under 1.0% and ideally under 0.5%.

More than two thirds of the states offer a state income tax deduction or tax credit based on contributions to the state’s 529 plan. (Seven states provide the state tax break on contributions to any state’s 529 plan.)

If your state provides a state income tax break, but has high fees, consider using a low-fee out-of-state 529 plan when your child is young, then switch new contributions to an in-state 529 plan when your child enters high school. This yields the best mix of low fees and state income tax breaks.

Every 529 plan has an account owner and a beneficiary (the child). The account owner should be the child’s custodial parent. With a custodial 529 plan, both the beneficiary and the account owner are the child. You don’t need to be the account owner to contribute to a child’s 529 plan.

When the account owner is the child or the child’s parent, the 529 plan is reported as a parent asset on the Free Application for Federal Student Aid (FAFSA), yielding a favorable financial aid treatment. When anybody else is the account owner, such as a grandparent, aunt or uncle, the 529 plan is not reported as an asset on the FAFSA, but distributions count as untaxed income to the beneficiary, yielding an unfavorable financial aid treatment. There are, however, a few workarounds for grandparent-owned 529 plans.

Sign up for automatic investments, where a monthly contribution is automatically transferred from your bank account to the 529 plan. Most 529 plans allow automatic investments to start as low as $15 or $25 a month. It is easy to increase the monthly contribution amount after you get started. You can also make lump sum contributions.

More than two-thirds of families invest their 529 plans in age-based investment glide paths. These investments change the mix of investments based on the age of the child or the number of years until college enrollment. They start off with an aggressive mix of mostly stocks when the child is young and gradually shift the portfolio to lower-risk investments as college approaches.

Review the asset allocation (mix of stocks and other investments) in your 529 plan at least once a year, to make sure it continues to meet your investment goals.

Don’t worry if your child doesn’t go to college or there is leftover money. There are many options. You can change the beneficiary to a sibling, grandchild or yourself. There is no age limit on 529 plans. You can use a 529 plan to pay for undergraduate or graduate school or for continuing education. You can also leave the money in the 529 plan or take a non-qualified distribution. (The earnings portion of a non-qualified distribution is subject to income tax and a 10% tax penalty, plus possible recapture of state income tax benefits. The tax penalty is waived in certain circumstances, such as receipt of scholarships and grants or use of the American Opportunity Tax Credit.)