College. It is one of the biggest expenses that those who have children will face during their lives. Only home ownership and retirement present larger financial commitments for most Americans.
The median price of a new home in the US was $300,200 in August of this year (US Census Bureau).
Retired households spend an average of $40,938 per year, according to the most recent Consumer Expenditure Survey conducted by the U.S. Bureau of Labor Statistics. The average household receives $27,120 per year in Social Security income, according to the Social Security Administration. That means that the other $13,818 must come from savings. Applying the oft-cited 4% rule would indicate that the household would need $345,540 in savings to fund a 30-year retirement.
According to the College Board, the average cost of tuition and fees and room and board for the 2016–2017 school year was $45,370 at private colleges, $20,090 for state residents at public colleges, and $35,370 for out-of-state residents attending public universities. So, ignoring inflation, four years of college typically costs $80,000 – $181,80.
So, how should you save for college? Let’s briefly review your options and identify the pros and cons of each approach.
Savings accounts are the simplest way to save money. Go to a bank or credit union, open an account and start saving. You can save as much as you want. Many banks offer FDIC insurance up to $250,000 on the account. Unfortunately, the interest earned is taxable as income. Also, banks are paying paltry interest on these accounts. You can find better rates offered by virtual (not brick and mortar) banks.
A brokerage account can be used to save for college. There are no saving limits and you can invest in many instruments (e.g. stocks, bonds, mutual funds and exchange traded funds) in these accounts. However, the dividends, interest, and capital gains they generate will be taxable.
Cash value life insurance allows the owner to save money in a tax favorable manner. The cash inside the policy grows tax-free. It is possible to take money out of the policy without incurring taxes. The problem with this strategy is that the withdrawals can serious weaken the policy and ultimately lead to its collapse in later years. When this happens, the owner loses the death benefit and can experience negative tax consequences. Life insurance is not counted when financial aid is determined.
Custodial accounts (UGMAs and UTMAs) give the owner of the account control over the account until the beneficiary reaches the age of majority (18 in Oregon, Washington and California). You can make gifts of up to $14,000 per beneficiary per year in these accounts. Gifts above this limit present tax challenges. The income in custodial accounts is taxable. Also, these accounts are owned by the student and are considered when financial aid is calculated.
Series EE and Series I Saving Bonds can be purchased by the student’s parent(s) (and held in the parent’s name) annually in amounts of up to $10,000. These bonds pay a fixed rate of interest. If the proceeds from the bonds are used for qualified educational expenses, the interest is free of federal and state taxes. Whiles these bonds are guaranteed by the US government, the current interest rate is miniscule.
Roth IRAs are attractive because, while contributions are not tax-deductible, the value in the account grows tax-free and distribution are tax-free if the money is used for qualified educational expenses. The problem with Roth IRAs, which were designed to save for retirement, is that contribution limits are low and there are income limits that prevent some people from using them.
Coverdell Education Savings Accounts grow tax-free. Contributions are made after-tax, but the withdrawals are tax-free when used for qualified educational expenses. Funds can be invested in a wide range of investment vehicles (savings, mutual funds, brokerage). Unfortunately, contributions are limited to $2,000 per account from all contributors. The Coverdell ESA can also be used to pay for K-12 expenses. There are income limitations for the accounts. Also, the account is a custodial account and ownership changes to the student at the age of majority.
529 College Saving Plans, which are operated by states and educational institutions, offer the greatest set of benefits. There are “prepaid” and “savings” 529 plans. The former allows you to pay in advance the costs of an in-state public college education. The latter resemble a qualified retirement plan like an IRA. The contributions can be invested in a variety of investments (typically through mutual funds and exchange trade funds). The account value grows tax-free. Distributions are tax-free, as long as they are used for qualified educational expenses. Many states offer contributors a state income tax benefit. Contribution limits are much higher than for the other tax-advantaged approaches. The owner controls the 529 account at all times. The beneficiary of the account (i.e. the student) can be changed if circumstances change. There are no income limits for the owner.
The above is meant to be an overview. There are details with these approaches that we have not covered. Please consult with your investment and/or tax advisor for specific advice and recommendations.