Saving For College
College costs keep rising and it seems there is no end in sight. The cost of college has been rising at an average rate of about 6% per year for decades. Research suggests that the rate of increase might be slowing, but it will still keep going up. At current rates, if you have a first-grader right now, college when your child is 18 will be twice what it is today.
Importance of Saving
I can't stress enough the importance of saving - and saving early! If you want to help your child or children attend college and don't want to leave them with six-figure student loan debt, it's time to start saving. As you know, time is a powerful lever. If you saved $350 per month for your child's education and started when he or she is a newborn, you would have saved over $135,000. If you waited until age five, you would have saved just over $82,000. If you wait until age 10 you would have about $43,000. That means that the waiting that first five years cost you $32,000 in growth. Waiting another five years costs you another $18,000.
Now, I know not everyone can afford $350 or more per month, but the point I am trying to make is that there are huge benefits to starting now.
Benefits of Tax Deferral
OK, I know you all know that you are supposed to save, but why not just put this money into a savings or investment account?
Not having to pay taxes on your investment gains every year is a great benefit. If you saved and invested the same amount in the same investments, but in one case it was a taxable account and the other account was a 529 plan, you end up with significantly more money in the 529 because you don't pay any taxes on the 529 growth, whereas in the taxable account you would have to pay taxes on the dividends and interest every year, as well as on the capital gains every time you rebalanced your portfolio. Those taxes add up.
529 Plans
You've heard about 529 plans before, I know. But they are a great tool and repetition is a great way to learn. With a 529 plan, you get to put away money after-tax, and some states actually give you a tax deduction or credit off of your state taxes to further the benefits. Then your money grows tax-deferred and if you pay for qualifying education expenses you don't pay any taxes on the withdrawals.
Further benefits include high contribution limits, currently $14,000 per year per child. If you are married you and your spouse can each put in $14,000 per year for a total of $28,000. You can even front-load your contributions. meaning that you can put five years worth of deposits into the account. So you can start the account with $70,000, or $140,000 if you are married. There are also no income limits on 529 contributions unlike other types of college savings accounts or IRAs.
There are a couple of downsides to be aware of, however. If your 529 money goes unused and you have to withdraw the money for non-educational expenses your would have to pay taxes on the gains as well as a 10% penalty on the gains. Some people keep unused funds in the account and change the beneficiary to their grandchildren, though. This money gets to grow for 18 or more years so it is a great way to help your kids pay for their children's college educations. 529 money is also counted as an asset for financial aid purposes if it's held by the parent. 529s held by grandparents don't count toward the financial aid asset calculation.
Roth IRAs
A Roth IRA is traditionally known as a retirement account. You put money in after tax, and that money grows tax-free and the withdrawals are tax-free if used after 59.5 years old. There are some relatively unknown perks of Roth IRAs. First, you always have access to the money you put into the Roth. Since you've already paid taxes on that money the government doesn't much care if you take it out of the account. If you are paying for education before you are 59.5 years old, you can still access the money you put in, as well as the growth without paying penalties. You would have to pay taxes on the growth still, but at least there are no penalties (it should be noted that the account needs to be open for at least five years before you can do this). The benefit of using a Roth IRA is that if the money doesn't get used for education, you can still use the money for retirement. Another great perk is that this money is not counted as an asset for financial aid purposes.
The Roth does have lower contribution limits, however. You and your spouse can each put in $5,500 into a Roth each year, plus an extra $1,000 if you are over 50. So, you can't nearly put away as much money as you could with a 529. Furthermore, there are income limitations. If you make over $186,000 as a couple the limit starts to go down. This limit is $118,000 if you are not married.
One strategy that might work for you (this is a big might) is if you have access to a Roth 401(k) at work, you have a contribution limit of $18,000 this year ($18,500 starting next year). If you max this out and leave your employer, you can roll your 401(k) into a Rollover Roth IRA and use that money to pay for college. That gives you a higher limit, but you have to quit your job...so it's a strategy that could work if you were planning on switching your job anyway. I would not recommend quitting just to be able to rollover the 401(k).
What To Do
Again, I can't stress enough the importance of saving early and often. Save some money into a 529 and some into your retirement accounts. Getting the ball rolling now will ease the cost of college in the future.
