Saving for College

Setting aside money for your child’s tuition can strain a family’s budget. Tuition costs have risen 225% over the past 30 years and show little sign of slowing down. According to CollegeBoard, during the 2014-15 school year, the average undergraduate in the United States paid almost $10,000 for one year at a public, in-state, four-year institution and over $30,000 for one year at a private, four-year institution.

the average undergraduate in the United States paid almost $10,000 for one year at a public, in-state, four-year institution

2014-2015 Tuition

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In order to afford higher education, prospective students and their parents need to start with a manageable college savings plan. There are several different options available, some of which carry benefits like tax deductibility and/or the opportunity to purchase college credits at a discounted price.

Stuart Ritter Vice President T. Rowe Price Investment Services

"Remember that saving for college doesn't have to fall only on your shoulders."

To better understand how to approach college savings, we spoke with Stuart Ritter, a financial planner and a vice president of T. Rowe Price Investment Services, Inc., which offers several college savings plans to its clients. Stuart currently helps design, build, and implement guidance and advice services for investors. A frequent contributor to T. Rowe Price publications, he has also appeared on ABC News, Fox Business News, and National Public Radio. Below, we will take a look at several of the most popular options for funding a college education, as well as Mr. Ritter’s advice for families.

What’s the biggest mistake you see families make when saving for college?

The biggest mistake parents make is not saving at all. Some parents forgo contributing to a 529 plan, assuming their child will qualify for aid or scholarships, but that outcome is not guaranteed.

In addition, individuals mistakenly assume that savings will hurt their chance of qualifying for federal loans, when in fact, federal financial aid is based primarily on your income. The amount you have saved has very little impact on that formula.

If your child does earn a full scholarship to college, you can change the account beneficiary to another family member — or even yourself.

Are there any upcoming changes that will affect how parents save for college?

We don’t anticipate any major upcoming changes that will affect how parents should be saving for their child’s college education.

Do you recommend different strategies for families with more than two children?

Yes. We recommend a different 529 account for each child because the money needs to be invested differently since each child has a different time horizon.

Do you typically advise parents to use a Coverdell Education Savings Account, 529, both, or neither?

T. Rowe Price recommends that parents use a 529 plan to save for their child’s college education, as there are some distinct advantages:

  1. You control the account and can change the beneficiary at any time, subject to IRS regulations.
  2. Any earnings are tax-deferred.
  3. Distributions are exempt from federal income tax if used for qualified education expenses.
  4. There are no income restrictions or limits to investing in a 529 plan.

A 529 savings account is a great vehicle to prepare for the rising costs of college and reduce your need to borrow money when your kids head off to school.

Coverdell Education Savings Account (ESA)

Coverdell ESAs offer increased flexibility when it comes to investment control, but are much more limited in terms of the amount of money that can be invested. If you have a significant amount of income to invest, a 529 account or a combination of 529 and ESA is usually the recommended route.

Income and Contribution Restrictions:

  • Single parents who earn an adjusted gross income of $110,000 or less per year — or two parents jointly filing who earn $220,000 or less — may obtain a Coverdell ESA for their child.
  • In any given year, the contributions toward this account may not exceed $2,000

Tax Considerations:

  • Coverdell ESA plans are not tax-deductible
  • If distributions cover more than the necessary expenses for school, they may be taxed up to 10%.

Financial Aid Considerations:

  • If the student is the official account holder and considered financially independent, this plan may affect financial aid eligibility.
  • If the student is a dependent or the parents are the account holders, then this plan should not affect eligibility for need-based aid.

To learn more about the Coverdell ESA, please review IRS Publication 970. You can enroll in this type of savings plan through different financial brokers. Major Coverdell ESA providers include TD Ameritrade, Scottrade, E-Trade, Schwab, TradeKing, and Capital One 360 Sharebuilder.

Uniform Transfer to Minors Act (UTMA)

Legal minors are not able to acquire stocks, bonds, mutual funds, annuities, life insurance policies, or other securities and monetary assets that require a signed contract. Additionally, parents or guardians cannot award these assets to minors, but donors may deposit said assets into a trust fund awarded to the minor when they reach legal adulthood. The UTMA account is an umbrella term that applies to any custodial trust. This includes a UTMA 529 account, which is essentially a 529 savings plan supported through a custodial trust. UTMA custodial accounts are rarely the most cost-effective college savings plan options; the exception to this rule is any family whose annual income is so high that their children will not be eligible for need-based financial aid.

Tax Considerations:

  • The only tax break for the student is an exemption on the first $1,000 of unearned income; the next $1,000 will be taxed at a rate of 15%. There is no contribution limit for UTMA custodial accounts, but depositing more than $14,000 per beneficiary will exceed the current limit for gift tax exclusions (and additional taxes will be applied).

Other Information:

  • Custodial accounts (unlike 529 plans or Coverdell ESAs) do not need to be applied toward qualified educational expenses; if the beneficiary does not attend college, then they can use the funds as they wish.
  • If the beneficiary is financially independent and they choose to enroll in a higher-learning institution, the custodial account will greatly impact their eligibility for need-based federal financial aid.
  • Custodial accounts for financially dependent students and UTMA 529 plans are considered assets of the parents, and so they stand to impact financial aid eligibility to a much lesser extent.
Investment Accounts

Some individuals may be tempted to use their retirement accounts as a means to pay for their children’s education; however, this is rarely a good idea. We’ll take a look at why some of the most common accounts shouldn’t be used for college savings.

401(k)

To use 401(k) funds to pay for an education, account holders have to declare a hardship withdrawal, demonstrating an immediate and strong need for the money after exhausting other resources. Account holders under 59 1/2 will receive a withdrawal penalty as well as having the funds taxed at a higher rate. In addition, these funds can affect a student’s eligibility for financial aid.

IRA

Using IRA funds to pay for your child’s education results in a reduction of need-based financial aid and extra tax penalties, making this an inefficient means to fund an education.

Mutual Fund

Paying for college with monies from a mutual fund is not as cost-effective as a 529 savings plan because 529 plans are tax-sheltered. Capital gain distributions from a mutual fund, on the other hand, are currently taxed at a rate of 10-20% (depending on the investor’s income bracket). Additionally, the appreciation of any liquidated mutual funds used to pay for college will also be taxed.

529 College Savings Plan

Also known as a “qualified tuition plan,” the 529 rewards plan-holders who save for college by providing them with tax advantages. The Securities & Exchange Commission (SEC) notes that two 529 account types are available: a prepaid tuition plan and a college savings plan. According to FinAid.org, all 50 states (as well as the District of Columbia) make college savings plans available to legal residents. Prepaid plans are available in 16 states.

Prepaid Tuition Plan

  • Enables the account-holder to buy credit units at higher-learning institutions that will be used in the future to pay tuition and administrative fees (as well as room/board, in some cases)
  • Essentially locks in tuition costs; enrolled students pay tuition at a fixed rate determined at the time of the initial investment, meaning rates won’t be adjusted at a later rate, protecting against future inflation
  • Plans often guaranteed by the state, which somewhat mitigates market risk
  • Most plans impose an age or grade limit on beneficiaries (such as 18 years)
  • Individuals may only set up a prepaid tuition plan during a standard enrollment period

The College Savings Plan

  • Allows the account-holder to set aside a portion of money for the plan beneficiary
  • Money saved will eventually be used to finance tuition, room and board, and other college expenses
  • Plans do not impose an age or grade limit, nor do they require state residency, which allows students and parents more flexibility
  • Generally no enrollment period
  • Slightly riskier than a prepaid plan, since tuition prices aren’t locked in, and the state assumes no responsibility for account funds if the market underperforms

Contribution Terms:

  • Prepaid plans typically involve a lump sum and schedule of installation payments based on the age of beneficiary and the number of years they are expected to attend school.
  • College savings plan involve a set maximum of money that is allowed to accrue in the account.

Tax Benefits:

  • Both accounts are tax free, and some states even provide tax benefits or other incentives.
  • Any funds not withdrawn and not used for higher education-related expenses may be taxed up to 10%.

Financial Aid Considerations:

  • Both of these options are considered parental assets and may affect the student’s eligibility for financial aid.
  • Please visit FinAid.org or Morningstar to view state-specific lists of all available 529 plans.

When is the best time to start saving for college? What’s the latest age parents can consider starting a savings account for their child?

It’s never too early or too late for parents to start saving for their children’s higher education. A 529 plan can be opened as soon as, or even before, a child is born. The earlier you start setting money aside in a 529 account, the longer that investment will have to benefit from tax-deferred growth potential. If you can’t afford to save enough to pay the whole bill, consider aiming to make a sizable “down payment” by saving for about half the costs.

What’s the average monthly contribution a family should consider to effectively save for their child?

To help families create a plan and start saving an appropriate amount for college, T. Rowe Price ran an analysis and found that a family would have to save over $400 a month from birth through the four years of college in order to cover the total costs at the average four-year, in-state public university. If this isn’t feasible, consider starting with half the amount and aim to increase it. If you can work a couple hundred dollars into your monthly budget to help offset the future expense of college, you will be so much better off by the time your child is ready to enroll.

A family would have to save over $400 a month from birth through the four years of college in order to cover the total costs at the average four-year, in-state public university.

What should you do if you haven’t saved for your child’s education?

The same thing you would do if you wanted to make any purchase but hadn’t saved for it (e.g., a car). Be very judicious about how much debt you take on. There are many colleges to choose from, at many different price points. Give careful consideration to the value you’re getting for your money given your financial situation.

What if you save for your child’s college education and they decide not to attend?

If the beneficiary listed on the account doesn’t go to college or, for any reason, doesn’t use all the money, you have options:

  • You can change the beneficiary on the account to another sibling, a cousin, a grandchild — or even yourself — and use the money for them without any penalty.
  • For 529 college savings plans, the money can also be used for higher education expenses other than undergraduate tuition, such as graduate school tuition, room and board, books, and supplies.
  • If you do need to withdraw funds for anything other than a qualified educational expense, you’ll need to pay income taxes on those earnings, as well as a 10% penalty on the earnings.

Is there any final advice you would like to give that wasn’t covered here?

Remember that saving for college doesn’t have to fall only on your shoulders. Aiming to save a down payment, asking friends and family to make gift contributions to your 529 plan, and having your child pay for a portion, as well as exploring alternative sources of college funding, such as scholarships, grants, and other financial aid, can all add up and make paying for college a reality.

cspn-logoCOLLEGE SAVINGS PLAN NETWORK: This website features a database of information about all of the college savings plans discussed in this article, as well as up-to-date news coverage of legislative developments, economic trends, and other factors that impact financial planning.
saving_for_collegeSAVING FOR COLLEGE: In addition to comprehensive information about different savings plan options, this site also offers blog posts, lists, infographics, interactive maps, and other forms of alternative media.
upromise-logo529.COM: This website dedicated to the 529 savings plan features specific information for parents, grandparents, distant relatives, family friends, employers, and financial advisors.
usnews-logoU.S. NEWS & WORLD REPORT: PAYING FOR COLLEGE: In addition to a section devoted to 529 plans and other college savings options, this page features information about financial aid, net tuition cost calculations and paying for online education.