How to Start a College Fund

November 10, 2021
investment strategy

If you’ve got a child in your life, chances are you’re already starting to wonder about the first big financial hurdle they’re going to face in life: college.

Going to college can offer young people incredible life opportunities. They’ll develop the skills they need to enter high-earning professions, discover new passions, learn independence, and make friends that will last a lifetime.

College opens many doors, but it costs a lot of money to open them. That’s why it’s critical you start a college fund as soon as you can.

This guide explains how much money you need to start a college fund, the different investment vehicles you can use, and the best way to set up a college fund for a child.

How Much Do You Need to Start a College fund?

We all know that college doesn’t come cheap, but how much do you need to save for your child’s tuition? Let’s break down the numbers.

For the 2020-21 academic year, private universities averaged $36,801 per year for tuition, accommodation, and “associated costs.” For reference, associated costs tend to cover things like administrative and registration fees.

Meanwhile, public out-of-state universities came in at $22,577 for 2020-21. Public in-state schools cost a lot less — but even then, you’re looking at an average of $10,116 per year.

US News table showing average college tuition for 2020-21.
(Image source)


Multiply that by four years’ worth of tuition, and it’s probably enough to send a lot of us into cardiac arrest. 

Unfortunately, there’s more. You’ve also got to consider all the extra stuff college kids need like textbooks, groceries, cash to travel home, and everything in between.

You’ve also got inflation to consider. 

On average, the cost of college tuition goes up by 8% every year. Statistically speaking, that means the cost of going to college doubles every nine years. If you want to start saving now to send a five-year-old to college in 13 years, you’ve got to be working toward a higher target.

OK, so that was the bad news. But there’s good news, too.

According to most financial planners, you should be working to try and save a third of your total target amount when saving to pay for a child’s college. 

That’s because the other two-thirds will normally get covered by financial aid, scholarships, or a student loan. This saving strategy is called “the one-third rule.” Hopefully, it removes a tiny bit of stress when you’re starting a college fund.

We’ve covered how much money you need to save, but how much money you need to start a college fund is a whole different ball game.

There’s a whole lot of flexibility in terms of how much you need to start saving, and a lot of that depends on the investment vehicle you choose.

What are Different Ways to Start a College Fund?

When it comes to deciding how you should start a college fund (and how much you’ll need to put into that account), you’ve got to sit down and think about what’s important to you, your investment objectives, and the timeline you’re working toward.

Some investment vehicles require minimum deposits, but others don’t.

To help wrap your head around each type of vehicle and how they work, we’ll quickly break down a few of the most popular methods to save for a child’s college fund.

529 plans

A 529 college savings plan is an investment vehicle that lets parents save for a child’s future higher education expenses. 

They work by allowing adults to invest after-tax money into pre-tailored funds filled with relatively low-risk stocks and bonds. Once the child you’re saving for is ready to start college, you can then withdraw the money tax-free (as long as it’s for educational purposes). 

529 plans are run by state governments rather than the federal government. There are two different kinds of 529s: a prepaid tuition plan or an education savings plan.

Prepaid tuition plans let you buy credits in advance for future tuition. Education savings plans let you open an investment account and save for future withdrawals.

A 529 savings plan is beneficial for a lot of families because they have a low contribution minimum, and you can withdraw your cash tax-free. But there are a couple of negatives, too.

Some U.S. states impose a penalty if you don’t use the money in your 529, and there are also pretty rigid restrictions on what counts as a “qualified education expense.” 

For example, if the kids you’re saving for decide to live in an apartment off-campus, the 529 plan you’ve been putting money into probably won’t cover that cost.

Custodial accounts

A UGMA custodial account is an increasingly popular investment vehicle adults can use to save assets that a child can access and spend when they reach the so-called “age of majority”. In most states, that age is either 18 or 21.

When an adult sets up a custodial account for a child, the adult becomes its “custodian” and manages all investments in the account until the child beneficiary comes of age. When this happens, all the assets in the account pass onto the (now grown-up) beneficiary, and they can spend it however they want.

The major benefit of using a custodial account to save for a child’s college fund is that they aren’t constrained by state definitions of what counts as a “qualified education expense.” 

A kid can use their custodial account assets to pay for a car to zip around campus in, food, plane tickets home for the holidays, a new laptop, or anything else they need.

Custodial accounts are also taxed at the child’s lower tax rate (up to a certain amount). This tends to save families quite a bit in tax payments.

a 529 plan is for education while a custodial account covers a lot more
(Image Source)

Coverdell ESA

A Coverdell education savings account (ESA) works a lot like a 529 plan. They’re used the same way 529s are: to cover certain education expenses. But unlike 529 plans, Coverdell ESAs are more lenient on how they define qualified expenses.

In addition to a child’s college tuition fees, Coverdell ESAs can also be used to pay for things like uniforms, tutors, and special needs services.

The benefits of the Coverdell ESA are that your withdrawals will be tax-free, and the funds you’re saving for a child can be applied to a wider range of college expenses.

The primary drawback is that Coverdell ESA plans have relatively low contribution limits. At present, you’re only allowed to invest $2,000 per year in an ESA. 

If the child in your life is planning to go in-state, that might be OK. But if you’re shooting for the Ivy League, a Coverdell ESA isn’t going to put a huge dent in your college fund.

Money market savings account

You could also choose to start a college fund for a child using a money market account. 

You can set up a money market savings account with most banks. Unlike normal savings accounts, money market savings accounts have higher interest rates. You’ll also benefit from insurance protection and get debit card and check-writing privileges.

But unlike the other vehicles we’ve covered, a money market savings account won’t give you any tax benefits. You’ll get taxed on your cash in the normal way. 

There’s also a pretty good chance the compound interest your account generates will be outpaced by inflation. That will really hurt your purchasing power when it’s finally time to start making payments to a college finance office.

What is the Best Way to Set up a College Fund for a Child?

No two students are alike — so why should two college funds look absolutely identical?

Deciding the best way to start a college fund for a child will depend on what you’re looking for in an investment vehicle. Consider your investment timeline, the income you have available to save or invest, and the projected college costs you’re going to need to cover.

It’s also important to note that you don’t have to pick just one college savings vehicle and stick with it. It’s always a good idea to cover all your bases, so you might want to consider starting nest eggs for the kids you love using multiple vehicles.

Illustration of woman and child sitting on EarlyBird logo.

For example, let’s say you decide to set up a state 529 plan alongside a UGMA custodial account. You’ll benefit from the unrivaled tax savings of a 529 plan. 

But by investing in a custodial account using EarlyBird, you’ll also be able to help your loved one finance all the college expenses that 529 plans would never cover. This includes a car to commute, plane tickets to visit home, paying for food, new electronics, and more.

Remember: college expenses go way beyond tuition fees and the dorms. Make sure you do everything you can now to cover all the bases so that the child in your life has everything they need to make the most of their time at college from day one.

Conclusion

College is expensive, and unfortunately, those costs go up by around 8% every year like clockwork.

The good news is that there’s a range of worthwhile investment vehicles available to start a college fund, including a 529 account, custodial account, Coverdell ESA, and more.

The investment plan that’s best for you will depend on a lot of different factors. But when starting a nest egg for a child’s financial future, it’s always a good idea to cover your bases. That means you might want to use multiple vehicles like setting up a custodial account and a 529 simultaneously.

So, are you ready to start a college fund for the children you love? Download EarlyBird and start saving today.

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