It’s no secret that the cost of higher education is continuing to rise. According to Education Data’s research, the average cost of college tuition in the U.S. is $35,720 per student per year.
As if that weren’t enough, college costs increase at an annual growth rate of 6.8%. To put this into perspective, the average interest on a savings account is 0.05%. Yikes!
Parents have multiple financial goals to juggle. From paying off the mortgage to saving for your retirement, there are several things that take priority. Still, it’s smart to think about your child’s college education expenses before that bill comes due. By planning ahead, you can continue to set your child up for success without breaking the bank.
Follow the Order of Operations for Saving for College
Before I do a deep dive into how much to save and where to save it, I want to explore parents' financial priorities.
Most of us learned the order of operations in algebra class. PEMDAS (or “Please excuse my dear Aunt Sally”) is an acronym that tells us the correct sequence of steps to solve a math equation. If we follow this sequence, we will correctly solve the equation, assuming our calculations are correct.
Well, the folks over at The College Investor have come up with an order of operations when it comes to saving for college education.
The key phrase is Y.E.S, and it is something that I think all parents should consider taking to heart.
Y.E.S stands for:
- (Y) You. Your financial priorities should be addressed before helping your children save for college. Paying your mortgage, paying off debts, handling monthly bills, and making sure food is on the table are immediate priorities that should come first. And as much as we want to give our children the world, don’t forget about YOU. Are you saving enough for your own retirement and emergency fund? Don’t sacrifice your own financial health. Remember, you can get a loan for college, but you can’t get a loan for retirement. A good analogy are the oxygen masks that pop down on airplanes. You have to take care of yourself first before you can properly help others.
- (E) Education Savings Accounts. Once you are taken care of, it’s time to begin saving for college! The best place to put your money is into an Education Savings Account. The most popular option is the 529 Plan, which I’ll go over later.
- (S) Savings. You might be wondering, “If I’m already putting money into an Education Savings Account, then why should I also put money into a regular savings account?” Well, there are some expenses that might not qualify as an education expense. For example, will your student need to drive a car to get to campus? What about new clothes? An allowance for going out with friends? The I.R.S. states that transportation, room and board, insurance, and sports do not count as qualified education expenses. If you’d like to help your child save for these costs, then a regular savings account will have to do.
Once your financial house is in order, it’s time to talk about how much you should really save for your child’s college.
How to Determine How Much to Save for College
While we know that the average cost of college is $35,720 per year per student, that’s only part of the equation. This number combines the averages for in-state, out-of-state, private, and public universities, which have widely varying costs. It also doesn’t factor in inflation (will the current 6.8% continue?) or any potential scholarships and grants your child may receive.
Each family is different, with unique circumstances and goals. Below are some different trains of thought. Pick the strategy that seems like the best fit, and then commit to saving for your child’s future.
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The 2K Rule of Thumb
Fidelity has developed an equation to help parents stay on track to cover half (50%) of the cost of a public 4-year college. They’ve dubbed this equation the “college savings 2K rule of thumb.”
It works like this:
Your child’s age x $2,000 = how much you should have saved.
For example, if your child is 5 years old, then 5 x $2,000 = $10,000. This means that you should ideally have $10,000 set aside for college by the time your child is 5. Again, this equation only assumes that you are paying 50% of the cost of a public 4-year program.
In a mathematically perfect world, this would mean setting $2K aside per year.
But don’t forget about the order of operations we talked about earlier. You might not be in a place to set aside $2K per year right now. That’s ok! You can always make catch-up contributions later on and don’t forget that a 529 Plan itself is an investment account that can accrue its own earnings.
The ⅓ Rule
The premise of the ⅓ Rule is that most people don’t pay for major expenses in one large sum (think: your car or house). Instead, the cost is spread out over a long period of time.
When it comes to college savings, the ⅓ Rule suggests that ⅓ will come from:
- Past income (savings and/or 529 Plan)
- Current income (when your child is in college)
- Scholarships, grants, student loans
For the sake of simplicity, let’s say your child’s tuition costs $100,000 over the course of 4 years. According to the ⅓ Rule, $33,333 would be from:
- What you’ve saved over the years
- Income during your child’s 4 years in school
- The form of scholarships, grants, student loans
Of course, the ⅓ Rule is a rough estimate. Some parents will have to save more, and some will inevitably save less. However, it is still an interesting breakdown to consider.
The Rule of 10 Formula
This is an easy-to-remember formula that the Lumina Foundation developed. The Rule of 10 suggests that:
- Families save 10% of their discretionary income
- Families do this for a period of 10 years
- Students work 10 hours a week while in college
Discretionary income is usually defined as your after-tax income after all your basic expenses and financial obligations are handled. These priorities should also include your own retirement.
The “Just Do It” Method
If the $2K Rule, ⅓ Rule, or Rule of 10 doesn’t seem right, there’s nothing wrong with just putting away as much as you can into a 529 Plan or savings account. With this method, decide what to save based on what you can afford, but remember to take care of YOU (Y.E.S.) first! Investing regularly as soon as you are able is key to success!
Types of Accounts to Save for College Tuition
It’s not just how much you save, but where you save it. Again, each family’s goals and circumstances are different, so it’s difficult to recommend the perfect savings vehicle. Still, saving money “imperfectly” is much better than not saving at all. Consider the different types of accounts below, and if you still have questions, I recommend getting in touch with your financial advisor.
- 529 Plan. The 529 Plan is by far the most popular choice for college savings. This tax-advantaged account allows you to contribute money regularly. The savings grow tax-free and can be withdrawn tax-free for qualified education expenses. 529 Plans are investment accounts managed by the states that rise and fall with the stock market, so the sooner you start saving, the more the money will grow.
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- Education Savings Accounts (E.S.A.s). E.S.A's are sometimes known as “Coverdell accounts” or a “Coverdell Education Savings Account.” E.S.A.s are similar to 529 Plans in that they are also investment vehicles. Still, E.S.A's give investors more control to make riskier investments. Another major difference is that parents can only contribute $2K per year to an E.S.A. In contrast, a 529 Plan has a higher contribution cap.
- Custodial savings accounts. Custodial accounts are also known as UGMA or UTMA accounts. As suggested by the name, custodial accounts are managed by custodians (typically parents) until your child reaches the majority age. Depending on your state, this can be 18, 21, or 25. Anyone in (or out) of the family can contribute to a custodial account with a gift tax exclusion. The only “downside” to a custodial account is that it’s a no-strings-attached, non-college-specific account. In other words, once your child comes of age, the money in the account belongs entirely to your child with no conditions. They can spend the money on whatever they want, even if it’s not education-related.
- A regular savings account. In addition to education-specific accounts, it is recommended to put aside some money in a savings account. Remember, not all costs qualify as an education expense. Transportation and boarding, for example, are not qualified costs and therefore cannot be paid with money from a 529 Plan. I personally like saving through C.I.T. Bank’s Savings Builder because they offer 0.45% APY for monthly savers. If you deposit a minimum of $100 a month, then you qualify for the 0.45% rate. This is a good incentive for saving early and regularly!
No matter how young or old your child is, it’s never a bad time to start thinking about college savings. Making the right plan for your child’s future includes making sure that you know all the options available to you, so I sincerely hope that this post helps you on your journey!