New Parents: Saving for a Child’s College Education

For new parents saving for a child’s college education can be confusing at first. If you are anything like me, the first set of questions you are asking are: How much do I need to save and where do I put my money? 

How much do I need to save?

To start, using a simple College Savings Calculator I looked up the projected cost of college my son would need. To cover 100% of the cost I will need to contribute $6,400 each year (or $530 monthly) for a total of $206,792 to meet that goal. I use an estimated return of 4% for all my forecasts.

Next, I researched what investment vehicles were most commonly used. This is where I contemplated if a 529 plan is the right vehicle for me. One side argues tax-differed growth with a 529 trumps the risk of not using the money. The other protests tax-deferred growth is not worth the risk of not using the money and being hit with the 10% penalty. 

What is a 529 Plan?

A 529 plan is a college savings plan sponsored by a state or agency. Savings grow tax-deferred and money you deposit may be eligible for state tax deductions (you need to check with the plan). Using the money in a 529 account for qualified higher education expenses (tuition, books, and other education-related expenses) are federal income tax free.

Benefits of a 529:

♦ Tax-deferred. Capital gains grow tax free when withdrawing on qualified higher education purposes. Qualified expenses include tuition, books, equipment, and sometimes room and board.

♦ Tax Deductible. Some state plans offer tax breaks on contributions or part of your contributions.

♦ Money is transferable. You can transfer balances from one family member to another, so if one child decides not to attend college you can use that money toward another child’s tuition.

♦ Automated investing. Many plans offer automated withdraw from your checking or savings account on a set frequency to encourage disciplined savings.

Drawbacks of a 529 Plan:

♦ You MUST use the money for education.  If not, you will be penalized 10% on the earnings to withdraw.

♦ High Fees. You are usually bound by the limited selections available by the plan so there tends to be higher fees when selecting funds through a 529.

Alternative Investment Vehicles 

Taxable Account: There are several advantages of using a taxable account vs a 529. There are no withdrawal rules and penalties that you find in retirement accounts or 529s. Taxable accounts let you withdraw your money for any purpose at any time. If you decide not to use the funds you can put it towards other goals. Your investment options are not limited and you can shop around for fees.

CDs/Bonds: Setting up a CD or Bond Ladder allows for a more worry free way to save for college without losing money. The “laddering” extends your maturities out at regular intervals and allows for you to deposit to account for volatility.

Roth IRA: You are able to withdraw contributions tax and penalty free for any purpose. Earnings or gains in the account grow tax-free but can only be taken out penalty-free after you turn 59 1/2. An advantage of investing in a Roth is when applying for financial aid. Retirement accounts are not considered assets so only when you withdraw for college will it be counted as student income on the following year’s FAFSA.

My Personal Plan

I am going to contribute $100 weekly and deposit all cash gifts my son receives towards college savings. The accounts I’ll be funding (in order):

♦ 529 plan: first 10 years or when the account balance reaches $100,000.

♦ Taxable account: remaining deposits here till total college savings reaches $200,000 or till my son graduates.

The Reasoning

We are not be too leveraged in a tax-differed account if my son doesn’t need the money for school. We can transfer funds to another child while savings in the taxable account be reclassified towards retirement.

In a few years I’ll write an update to how this strategy played out but please feel free to provide feedback and let me know your strategy.

Note: All information found here are for informational purposes only and I am not providing any personal investment advice. 

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