You want to give the children in your life the best opportunity to succeed.
And, in this day and age, that usually includes a post-secondary education.
The problem is that college is more expensive now than ever. And the cost of tuition seems to only keep going up with each passing year.
Thankfully, there are special types of savings accounts and plans that allow you to save for college. They let you earn interest and grow your initial investment. All while taking advantage of income tax benefits for both you and the recipient.
This article will teach you the best ways to save for college. Depending on your personal situation, you may choose from one of several different types of accounts.
There’s also some other strategies to consider when it comes to saving for college that we’ll discuss. These can either help boost your savings or reduce education expenses.
When Should You Start Saving For College?
The earlier that you start saving for a child’s higher education, the easier it'll be to save enough money by the time that they attend school.
By starting to save for college as soon as a child is born, you can get the maximum benefit out of the compounding effects of interest.
In other words, the money that you earn on your investment will compound over time.
You don’t just earn interest on your initial investment; your savings generate additional money all on their own. In this way, additional money gets re-invested to continue producing even more interest in the future.
The earlier you start investing, the more time the money has to grow and build upon itself. Similar to a rolling snowball that continues to grow larger over time.
Even if the child in your life is older, though, it’s never too late to get started. Very simply, the best time to start saving for college is today.
How Much Should You Save For College?
One of the most popular ways to look at saving for college is the one-third rule.
This rule dictates that:
- A third of college costs should be covered by past income (in other words, savings).
- A third of costs should be covered by income earned while the child is attending college.
- A third of costs should be covered by future income (received during college in the form of student loans).
The first third is money that you invest as a child grows up. This money will benefit from compound interest and grow over time, as discussed in the previous section.
The middle third takes advantage of the fact that your salary will likely be higher while a child is attending college. You’ll have more disposable income to pay for college during these years than when the child was younger.
For the final third, student loans are used to cover any shortfall that you won’t be able to pay during a child’s education.
How much do you need to save for college in total?
College costs tend to increase by a factor of three over any 17-year-period. Basically, from birth to college enrollment.
If you’re following the one-third rule, that means you should be saving the full cost of a college education in the year that the child was born.
Keep in mind that this amount will vary depending on a couple of factors:
- Whether the child in your life decides to attend an in-state or out-of-state college.
- Whether the school they attend is a public or private institution.
So, to some degree, you’ll need to predict which type of college the child is most likely to attend.
How To Save For College: Important Considerations
There’s more to think about when saving for college than just regularly depositing money into a savings account.
There are many other ways to save than putting your pennies under your mattress.
Before we dive into our recommendations, though, there are a few considerations you should keep in mind when planning how you’ll finance a child’s college education.
Risk vs reward
Investing and saving money comes with some inherent risks.
If you choose investments that provide a higher return, it’ll also typically come with a higher level of risk.
However, if you avoid all risk in your investments by keeping everything in cash, your savings won’t be able to keep up with inflation.
There’s a balance you’ll need to strike to best save for a child’s higher education.
Risk is typically managed through asset allocation.
Your asset allocation is how your savings are split between different types of investments.
It’s normal to change the asset allocation of a child’s college savings over time. Usually the asset allocation is based on either the child’s age, or their projected college enrollment date.
When a child is one year old, you’ll want a more aggressive portfolio with a higher proportion of the money invested in stocks.
Once a child is 16 years old, you may want to protect the savings by shifting to a less-risky allocation, which usually includes more bonds and cash.
If the idea of shuffling a child’s portfolio around seems overwhelming, don’t worry. In many cases, an investment advisor or other financial professional will help to make these adjustments over time.
To maximize the net returns on your college savings, you’ll want to minimize fees.
It’s important to read the fine print and consider all fees when choosing between different types of college savings accounts.
A Look at the Options:
Alright, enough background. Let's break down the best ways for you to start saving for the child in your life's college education.
1. A 529 College Savings Plan
A 529 college savings plan is a special kind of savings account that you can use to save money for a child’s college education.
It’s a state-sponsored plan that allows you to withdraw funds later on for most types of college expenses, completely tax-free.
When you put money into a 529 plan, you save money in terms of income tax on your earnings. You also don't pay any income tax when the child withdraws the money to spend on a qualified education expense like tuition and textbooks.
A 529 plan is one of the best ways to save for a child’s college education, and it can help to save parents a lot of money, too.
529 plans don’t have an annual contribution limit. There are maximum limits on the total amount that you can put into a 529 account over the child’s lifetime, but these limits are quite generous.
The maximum limit may range from $235,000, to $529,000, depending on which state you live in.
529 college savings plan drawbacks:
A 529 college savings plan offers great benefits, but there are also some drawbacks to be aware of.
Investment choices in these plans can be limited to FDIC-protected money markets, stock funds, and bond funds.
529 plans are also limited in terms of how you can spend your money.
The money must be used for higher education. The penalties for using funds for anything besides qualified education expenses can be harsh. You’ll incur the regular income tax rate on the funds, plus an additional 10% penalty rate.
If you withdraw more than $14,000 for tuition in any one year, you could also be subject to the IRS gift tax.
529 plan alternatives:
2. Custodial savings accounts
A custodial savings account is simply a savings account that an adult controls for a minor. In most states, the funds are held until a child turns either 18 or 21. The funds are then transferred into the child’s custody.
A custodial account is more flexible in terms of what you can spend your savings on. You’re also free to invest the money however you see fit.
However, you don’t get the same tax benefits from a custodial savings account as you would from a 529 plan. Saving money for a child in a custodial account can also hurt their financial aid prospects more than a 529 plan.
You can learn more about the differences in our article here:
It’s recommended that you only use a custodial savings account to save for college if you’ve already made your maximum contributions to a 529 plan or ESA (educational savings account). Or if you don’t qualify for either of those kinds of accounts.
A custodial account can be used for so much more than just saving for college though. Once a child turns 18 or 21, they can use the funds any way they want.
You might want to set up a custodial account to buy a new car or fund an extended trip after a child graduates from high school. You can also create a custodial account for grandchildren, a niece or nephew, godchildren, the children of friends, or any other child in your life.
EarlyBird is a Registered Investment Advisor (RIA) that offers a type of custodial savings account called a UGMA (Uniform Gift to Minors Act.)
3. Prepaid tuition plan
Some public colleges or universities will let you buy a year’s worth of tuition at current prices.
It works the same way that “forever stamps” allow you to pay for postage and have it always retain its value. You pay for a year’s worth of tuition now, and it'll always be worth a year’s tuition, regardless of future price increases.
Prepaid tuition can be a good way to counter rising prices and inflation. However, not all institutions offer these kinds of plans.
A prepaid plan is also quite restrictive. Not all institutions may offer the major that the child in your life wants to study. You also take away the child’s freedom to pick what school they want to go to.
4. US savings bonds
US savings bonds offer tax-free interest when the savings bond is contributed to a 529 plan or used to pay for college.
However, they offer a very low interest and yield. It’s better to buy bonds than simply saving cash for a child’s education, or not saving at all. But there are better options available.
5. Roth IRA
Like a 529 plan, a Roth IRA (usually used for retirement savings) also offers favorable tax treatment and a tax-free return of contributions.
However, a tax-free return of contributions from a Roth IRA gets reported as untaxed income when an applicant completes their FAFSA (Free Application for Federal Student Aid).
Untaxed income has the same impact as taxable income when it comes to aid eligibility. So if you think the child in your life will require financial aid or student loans to pay for college, a Roth IRA isn’t recommended.
Roth IRAs also have annual contribution limits of only a few thousand dollars per year.
6. Coverdell education savings account (ESA)
An ESA can be used to pay for college as well as private K-12 education. However, it has several more limitations when compared to a 529 plan.
Annual contributions to an educational college saving account from all sources are limited to just $2,000 per year. This can make it particularly difficult if you’re starting to save for a child’s education later and trying to make up for lost time.
Contributions to an ESA also have to stop once a beneficiary reaches 18 years old. The account also needs to be fully distributed by the time they’re 30.
For more on all this, we've compared two of the primary options in our guide to Coverdell vs 529 plans.
Other Ways To Start Saving For College
Everybody’s situation is different. While it might sound nice to contribute the maximum amount to our child’s 529 plan or another type of savings account, that simply isn’t practical for many people.
Here are some other ways that you can fund a child’s post-secondary education if you aren’t able to regularly contribute to a college fund.
Apply for scholarships and grants
Scholarships and grants are free money that you don’t have to pay back. It just takes time to fill out forms and apply for them.
Encourage the child in your life to apply for any scholarships that they’re eligible for. Even small amounts like $500 grants here and there can really add up.
Help support and encourage the kids in your life when they show a talent for athletics, academics, or any extracurricular activities that may lead to scholarships.
Enroll your child in AP classes
AP credits count as college credits. So every AP class that a child takes is one less class that you’ll have to pay for in college.
Apply for financial aid
Every student should fill out the FAFSA (Free Application for Federal Student Aid). Even if you don’t plan to use it, it’s still good to know what financial aid you’re eligible for.
The FAFSA covers things like state aid, school aid, federal grants, and work-study programs.
Encourage the child in your life to get a part-time job
A part-time job allows a child to gain valuable work experience for their resume while also helping to pay for some of their own schooling.
Depending on their course load, they might be able to work part-time year-round. Or they may just work full-time in the summer and focus on their studies during the school year.
Be sure to help them open a savings account so they have a place to safely keep their money.
Banks normally offer students special accounts with no fee or minimum balance requirements. If the child in your life is under 18, you’ll need to be the joint account holder while they’re a minor.
Start Saving For College
Sending the important children in your life to college has a significant cost associated with it. So you’ll want to start saving as soon as possible.
A 529 savings plan can be the best way to save for college costs. You may want to look into other options as well.
A custodial savings account provides a less-restrictive savings option. You can use the money in a custodial account to help a child in your life open a business, buy their first car, or travel the world after graduation.
That's the kind of account that EarlyBird offers. We're the simplest way to invest in the financial future of the children in your life. Visit getearlybird.io to learn how you can launch an investment account in just a couple quick minutes.
This page contains general information and does not contain financial advice. All investments involve risk. Any hypothetical performance shown is for illustrative purposes only. Actual investment performance may be different for many reasons, including, but not limited to, market fluctuations, time horizon, taxes, and fees. Please consult a qualified financial advisor and/or tax professional for investment guidance.