School’s In

LOOKING TO PAY for your child’s college? With costs increasing at an alarming rate, you may feel like you’re swimming upstream. Much like saving for retirement, you need to begin socking away money for college as early as possible. Each year that passes is one less year that your savings have the opportunity to grow.

Start by getting a clear picture of college costs today. You can use the Department of Education’s College Scorecard to look up the annual cost of specific colleges. Unfortunately, you will need to adjust these numbers for inflation between now and when your youngster attends. I typically assume 5% per year.

I favor a three-legged approach to college savings. What does this mean? You pay for college from three different sources—a 529 college-savings plan, a taxable brokerage account and what I call “miscellaneous”:

• The first third of your total college funding will come from a 529 plan. A 529 allows you to contribute after-tax dollars, invest those dollars on a tax-deferred basis and eventually withdraw the proceeds tax-free for qualified education expenses.

The tax advantages make this account a great way to start saving. Why not fund all of college with a 529 plan? I prefer to maintain some flexibility. Any money that goes into a 529 plan needs to be used for qualified education expenses. If you save too much in a 529, any growth that gets withdrawn for other purposes is subject to income taxes, plus a 10% penalty.

• The next third is paid for with a regular taxable brokerage account. There aren’t any tax advantages, but flexibility is maximized. If you need to use the funds to pay for your child’s college expenses, the money’s there. If you don’t need it for college, you’re free to use the money for other needs.
• That brings us to “miscellaneous.” The final third of your college funding will come from current income, any scholarship money and tax credits while your kid is in college. Scholarships are given based on both financial need and merit. The two tax credits are the American Opportunity Tax Credit and the Lifetime Learning Credit. These can provide up to $2,500 and $2,000 in annual tax credits, respectively, but your family’s income has to fall below certain thresholds.

How does this all stack up? Let’s assume you have a newborn that’s going to attend your local state university, with a total annual cost today of $20,000. In 18 years, this cost grows to about $48,000, assuming 5% inflation. To fully fund four years of college, you’ll need to come up with some $200,000.

With the three-legged approach, you need to accumulate two-thirds of this amount by the time your child reaches age 18, or $133,333. Assuming an annual growth rate of 5% on your investments, you will need to save $381 per month if you start when your kid is born. What happens if you wait to start saving until your child is five years old? The required monthly contribution increases to $608.

What about the $66,667 for the third leg? This is equal to $1,389 per month for four years. To cover part of this $1,389, you’ll have the $381 you were previously saving every month for college, plus about $400 per month will be freed up once your kid is out of the house. A $2,000 annual tax credit will give you another $167 per month. That leaves a gap of just $441 per month. This might be funded with scholarships, your child’s earned income or student loans.

Ross Menke is a Certified Financial Planner. His previous articles include Into the Woods, The Happy Employee and Par for the Course. Follow Ross on Twitter @RossVMenke.

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David Baese

5 years ago

Ross,
Regarding the second 1/3 there are some tax advantages to paying for a college education out of a brokerage account. You can gift appreciated securities to a student, let the student sell them in his or her presumably lower tax bracket, and pay the lower tax bill. Another angle would be to let the student get a student loan, gift the appreciated securities to pay off the loan in his or her presumably lower bracket after graduation, and let the graduate build up a credit score by paying off the loans early. Grandparents can also do this. It ought to work.
Dave

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