College costs continue to rise at a torrid pace. If parents want to send their children to a 4-year public university today, they need to come up with around $44,000 on average for in-state tuition or nearly $120,000 for an out-of-state school. You can triple or quadruple that for a private university. Room and board add another $45,000 over four years. What are parents to do?
Parent’s Options for Funding College
Nearly all my clients who are parents have indicated they want to ensure their kids have access to a college education. But depending on their stage in life and other individual circumstances, they may choose different paths to achieve that goal.
Essentially, parents have three options for paying for college:
- Fund it at a discount by saving early and often.
- Fund it from current earnings.
- Fund it with future dollars.
The first option is the least costly because you’re using the power of time and compounding to grow the funds. You are using discounted dollars to pay for future costs.
The second option is more expensive because you’re paying for college from current earnings that must be diverted from other critical goals, such as retirement or lifestyle needs.
The third option is the most expensive because you (or your student) borrow the money and repay it with future dollars that include an interest component.
If your child is on the final approach to entering college, you’re limited to options two and three. Your only course of action is to apply early for scholarships and financial aid as you prepare to recalibrate your budget. Some parents follow the community college route, which provides their children with everything they need to complete their undergraduate work while saving tens of thousands of dollars.
The best option is to prefund a college education with savings, and the earlier you start, the cheaper it will be. When it comes to achieving your most important financial goals, time is your most valuable asset. When we waste time, the cost of our goals increases. For example, if your goal is to have $120,000 available in 15 years, assuming a 5% annual return, you would need to save $288 a month. If you wait ten years to start saving, the cost will go up to $750 a month. Wait 15 years to start, and you’ll need to come up with $1,716 a month.
Choosing Which Goals to Prefund with Savings
The reality for many parents is the goal of sending their kids to college may be competing with other pursuits. They may have five or ten life goals that are important to them, and they may not have the capacity to invest for all of them. So, they have to consider trade-offs. Some goals may have to be funded in real-time from current earnings, while others can be prepaid with available savings. Which goals make sense to pay for in cash, and which make sense to prefund with savings?
There are several factors to consider when choosing which goals to prefund versus which to pay as you go; chief among them is tax efficiency. In other words, does it make sense to save for a goal using after-tax dollars only to pay additional taxes to savings to pay for the goal? Why incur that extra cost if you can save for another high-priority goal using tax-advantaged dollars, which would amplify the savings available? That’s a trade-off that makes sense all day long. Better to pay for the first goal out of earnings and only be taxed once (on the earnings) than to be taxed twice—once on the earnings and again on the savings.
The second goal, which, in this case, is funding a college education, can be achieved using a 529 college savings plan, which has multiple tax advantages. Created by Congress to incentivize individual savings, 529 plans are one of the most compelling savings vehicles available. If you have the opportunity to save for college, it would be a sin not to use it.
A 529 College Savings Plan Tilts the Playing Field in Your Favor
The plans are offered through the states (though you can invest in any state’s plan). There’s no limit on the amount that can be contributed annually, but it would be essential to coordinate your contribution with the annual gift tax exclusion, which is $16,000 ($32,000 per couple) in 2022. You can select a mix of investments offered by the plan, and there are no taxes on the earnings or gains in the plan. If the funds are used to cover qualified college expenses (or even K through 12 expenses for private schools), they can be accessed tax-free. Funds not used for one child can be used for other children or yourself.
Whether your kids are 18 years out or five years out from entering college, taking advantage of a 529 plan’s tax breaks makes much more sense than using current earnings or loans. It’s the same concept as using qualified retirement plans to save for retirement—why wouldn’t you?
Anytime you need to fund high-priority long-term goals, always take advantage of time to compound your money, and never pay taxes on money used to fund a goal if you don’t have to.