Last week we talked about the rising cost of a college education and some of the practicalities around that. This week we will talk a bit about how to pay for college costs. Don’t worry, I’ll go into more depth later on because I like to rub it in! Just kidding, it’s really because I have more to say about financial aid. Ok so just how are you going to pay for all of this education?
Just like I bring bad news, I also bring good news, and the good news is that the money you save for college will probably play only one part- albeit a big part - in the successful financing of your child's college education. There are lots of other things that can come into play to help you cover costs. It’s best to think of your college savings as just one block in a block tower or one piece of the puzzle. In addition to your college savings, some of your child's education costs can be covered by:
Financial aid can include:
- Student loans
- Work-study stipends from both the federal government and your child's college
- Your income during the college years
- Part-time job earnings from your child
- Borrowing options such as a home equity loan
- Creative cost-cutting measures, such as having your child attend a community college for two years before transferring to a four-year college or encouraging your child to choose an accelerated program where he or she can graduate in three years instead of four, and
- Gifts from grandparents or other relatives.
So my best two pieces of advice are: 1, teach your kids to be smart and 2, be nice to grandma. I’m kidding - but those couldn’t hurt.
My real advice is that, even though college costs are high, it’s good to think of your savings as a down payment of sorts on the total cost, similar to a down payment on a home. A smart goal is to aim to save at least 50% of your child's projected college costs. Again, I'll use a real-world example to help show you how this works.
Setting a Savings Goal1
So, your college fund can grow over a period of years if you invest a certain amount of money each month and earn a certain rate of return. First, let’s assume an average after-tax return of 6%. Under these assumptions, if you were to save $100 a month for 15 years, you would have almost $30,000 in your child's college fund by the end of that time. The sooner you start saving, the more time your money will have to potentially grow. This is a pretty obvious point, but I must annoy you with it again and again and again until you listen to me.
Now you may be thinking back to earlier when I listed all the demands on your hard-earned dollars, which I’m sure you enjoyed, and you may be thinking, "I can't possibly save $200 or $300 a month….” I have bills and taxes to pay too. A good plan is to start with whatever amount you can afford and add to it over the years with things like raises, bonuses, tax refunds, and unexpected windfalls. And guess what? As your child gets older, he or she can also contribute to the fund by routinely adding a portion of birthday or graduation money, as well as earnings from a part-time job. They might not like this option very much, but it tends to be the parent’s personal favorite.
Regardless, the important thing is to start saving, even if it's not as much as you'd like.
And once you do, you might start wondering where to put it. That’s why our next topic will be all about where to put your money once it starts showing up.
College Savings Options
You have several college savings options to choose from. Some of the most popular include 529 plans, Coverdell Education Savings Accounts, mutual funds, stocks, exchange-traded funds, bank savings accounts, money market funds, certificates of deposit, and Roth IRAs. Even though Roth IRAs are first and foremost a retirement savings vehicle, some parents have found they work pretty well as a college savings tool, too.
It’s important to keep in mind that some of these options are taxable and others aren't, which I'll talk about more in a moment.
Before I do, though, I'd like to mention that we aren't going to spend time talking about traditional savings accounts, money market funds, or certificates of deposit. That's because these vehicles can be an excellent place to park your short-term savings, but they probably shouldn't be the core of your long-term savings strategy. Remember that super accelerated college inflation we talked about? I’m sure it was hard to forget. Well, these traditional savings accounts have rates of return that most likely won’t keep up with the college inflation pace, and they don't offer any unique tax advantages for college savers.
Instead, we will focus on the options that offer some type of federal tax advantage if they're used to save for college. These include 529 plans, Coverdell Education Savings Accounts, and Roth IRAs.
You might be wondering, “why the focus on tax-advantaged strategies?” Well, taxes can take a bite -- sometimes a pretty significant bite - out of your overall college nest egg, depending on the type of account you use to save. To get ahead in the college savings game, you should use tax-advantaged strategies whenever possible. Next week, we will discuss this in more depth.
Well, folks, that’s enough for this week, although I went a bit longer than I like to on this blog, my goal was to create a knowledge base so we can dig deep in the following weeks. Happy reading and I will see you next week when we talk about ways to save for your children’s college journey.
P.S. If you enjoyed what you've read here and found it beneficial, we encourage you to share it with your friends and family. I firmly believe that an educated investor is more confident, which leads to healthier finances and fewer sleepless nights.
Until next time...
1 Figures are based on a 6% average annual after-tax return. These hypothetical examples are used for illustrative purposes only and do not represent the performance of any specific investment. Fees and expenses are not considered and would reduce the performance shown if there were included. Actual results will vary. These examples assume a fixed annual rate of return, but rates of return will vary over time, particularly for long-term investments.