Saving for Your Kids’ College Education: A Primer

Excerpts of this post originally appeared on the San Francisco Moms Blog

How much?

College has become expensive! In fact, over the past decade, the cost of college has gone up by over 60%! 

As a financial advisor and father of two young daughters under four, I have thought a lot about how to tackle saving for college. I’ve seen firsthand how student loan debt can be soul-crushing, career-limiting and even change the calculus of starting a family.

The average student now graduates with $37,000 of debt before ever making a penny! I have seen worse and work with clients who owe hundreds of thousands of dollars in student loans. This has really become a modern ball and chain.

Does it make sense for you to save for your kids' college? And, if so, what is the best way to do it?

Enter the 529 plan

The 529 plan allows you to save and invest money that will grow tax-free as long as it’s used for education. It’s not just college anymore. The new 2018 tax law changes offer a bit more flexibility allowing you to spend up to $10,000 from your 529 plan tax-free for primary school.

In some states, you can get a tax deduction for your contributions, but, unfortunately, California doesn’t offer one. Since they are state-run plans, you will need to find a state to sponsor the plan.

How much can I contribute to a 529 plan?

You can invest up to the expected cost of five years of college per beneficiary (i.e. your child who will receive the money). Depending on the state plan, this can be up to $400,000. If you start early, with a decent chunk of savings, it can really make a big difference!

If you stashed $10,000 under your mattress and put aside another $300 each month, you would have $89,200 stashed away in 18 years. This is earning no interest at all and losing purchasing power to inflation.

However, if you read this post (or worked with a trusted advisor) and contributed the same amount to a 529 plan invested in the market with a 6% compounded return, you would have $172,906 dollars saved tax-free for college!

Compounding interest is your friend and you should take advantage of it! It increases your savings by $83,000 and, best of all, it’s tax-free! 

What’s the catch?

The drawback of the 529 plan is that the money must be used for educational expenses, like tuition, room and board, laptops, books, etc. Otherwise, you will be penalized 10% on the earnings when the money is withdrawn. This means the IRS would charge you taxes plus a penalty on any of the earnings or growth.

For example, if you put in $10,000 and it grew to $15,000, then $5,000 would be subject to taxes and a 10% penalty if it’s used for something other than education.

Still, the 529 plan does offer a lot of flexibility. Maybe one of your kids decides to run off and join the circus instead of going to college. You can always change the beneficiary to another child, yourself, or any other family member.

Likewise, if your son or daughter gets a scholarship, you can take the proportional amount of the scholarship out of the 529 plan without paying a penalty, or he or she can use the money for a postgraduate degree.

How much should you save?

If your objective is to pay for all of your children’s higher education, then it makes sense to target saving around 50% to 70% in the 529 plan and cash flow the rest (i.e. pay out of pocket with your current income).

When it comes to education, the apple usually doesn’t fall too far from the tree. I recommend averaging out the current tuition from your and your spouse’s alma matters, then adjusting for education inflation at 5%.

Warning: the numbers in 15 to 20 years can be eye-popping. My wife went to Babson College in Boston and the full sticker price for my oldest daughter to attend would be $570,000. Yikes!

Invest taxable assets instead

Maybe you aren’t 100% sold on your kid going to college. Another option is to just invest in a taxable account. You can do this in a couple ways.

You can open up a UTMA (Uniform Trust to Minors Act) for your kid, which does provide some tax benefits, or you can earmark an investment account in your name that is for the kids.

You will be the custodian of the UTMA until your child reaches adulthood. The drawback to the UTMA is that the money technically belongs to your child and they have full legal control at the age of 21.

Most clients who use this won’t tell the kids about their money until they are at a responsible age like 25 so that they don’t blow it on something shiny and expensive.

And who knows? Maybe, in the future, kids won’t go to college, and we’ll all just have chips implanted in our brains a la “The Matrix.” Your kid can then use the funds to start a business or maybe use it as a down payment on a home without any strings attached. It’s nice to have options.

Bad advice

I’ve heard of people using whole life insurance as a vehicle to fund college. This is a major mistake! Whole life insurance and variable universal life are extremely expensive. Yes, there are some tax benefits, but the costs completely outweigh the positives.

Life insurance is very important, but it should be used to protect your loved ones, not as an investment.

The insurance sales pitch is that the money won’t show up on your financial aid form. Yes, this is true, but only 5.64% of the 529 plan counts toward assets for the kids on the FAFSA form, anyway. If you have $100,000 set aside in the 529 plan then financial aid would only take $5,640 into account.

Insurance agents love these products because they pay a big commission, not because it’s actually in your best interest. Run, don’t walk away.

Financial freedom

When it comes to saving for my kids' college, it's all about increasing their financial freedom, so they can dream big and take risks after school, instead of being shackled by debt.

Yes, the cost of education has gone up quite a bit, but there are a lot of creative ways to limit the impact of student loans and still graduate with a degree from a great university.

Online education, community colleges, the potential for free college tuition legislation, and other future, yet to be fully conceived, options (e.g. brain upload?) will hopefully open up the doors to a more educated society with less debt.

Not sure where to start? Schedule a quick 20 minute intro call to see how I may be able to help.