College Planning

August 4, 2016 / Ted Braun

College Savings: How a Little Planning can go a Long Way

What types of options do I have when it comes to saving for my children’s college education, which is best and why?

While the cost of college continues to increase at a torrid pace, there are ways to prepare for one of the biggest expenditures in your lifetime. With appropriate planning, disciplined savings and thoughtful conversations with your child you can significantly improve your chances for success.

Power of Starting Early & Saving Often

Just as the case with any savings goal, the sooner you start and the more disciplined your approach to saving the better off you are. The power of compounding cannot be overstated when looking at an 18 year time horizon. As an example we’ve created the table below to highlight the power of compounding and the difference in total savings when someone starts saving $1,000, $500 or $250 a month at the birth of their child vs. their 5th birthday using a tax-deferred vehicle.

Savings Amount Savings Beginning at Child’s Birth Savings Beginning on Child’s 5th Birthday Difference in Final Account Balance
$1,000 per month $349,345.16 $219,171.86 + $130,173.30
$500 per month $174,672.58 $109,585.93 + $65,086.65
$250 per month $87,336.29 $54,792.97 + $35,543.32

 

Assuming a 5% annual return you could have approximately $130,000 more in savings when the child turns 18, while only contributing $60,000 extra dollars by starting at birth vs. age 5 (when saving $1,000 per month). As you can see, before worrying about the actual cost or which school your child will attend, the most important action you can take is to simply begin saving sooner than later.

Impact of Inflation on the Cost of Education

Just as the power of compounding can dramatically affect the amount of your savings, so too can inflation affect the cost of a college education. Recent research suggests that college tuition could continue to increase anywhere between 6% – 7% over the next several years. This is nearly three times the current rate of inflation for the majority of consumer products and services.

Using our Financial Planning software “NaviPlan”, we have created the table below to highlight the dramatic impact inflation can have on the cost of secondary education over the next 18 years. Using current tuition figures (room & board included) for a PA resident and a 6% rate of inflation, we were able to highlight the projected cost for the following four well-known schools at different cost levels.

School Current Annual Cost Projected Cost in 18 Years
West Chester University $17,589 $219,627
Penn State University $28,434 $355,045
Ohio State University $39,031 $487,366
University of Pennsylvania $63,526 $793,226

 

Our intent is not to frighten or discourage existing or future parents of children planning to go to college, but rather to highlight the importance of planning ahead for what could be a large expense for you and your family. As your child matures and begins thinking about what college they would to attend, what career they want to pursue, it is absolutely critical that you involve them in the financial requirements to obtain a college education. We recommend that you discuss with them the costs and the impact that large amounts of student debt can have on their ability to purchase their first home or start their own retirement savings. It is not easy to have these conversations, or for a teenager to have the foresight to look past the fun, excitement, and in most cases life-changing experiences involved in attending college, but HFA can help!

As you begin having conversations with your children, contact HFA for some help. Sometimes words can be difficult to fully comprehend for a teenager but when there is objective data, interactive charts and real numbers in front of them, it can sometimes be easier for them to see what kind of long-term impact college decisions can have.

Savings Vehicles

After making the decision to start saving, the next decision point is what type of account and or investment vehicle best suits your needs and goals. While there are several vehicles that can be used to save for college expenses, we have narrowed that list to what we believe are the following best options.

529 College Savings Plans

By far the most widely used vehicle for college savings are the 529 plans which are named after the section of the Internal Revenue Code that authorizes such plans. These plans are established by various state governments. With a lengthy list of “pros” and only a few “cons” related to using this type of vehicle it is an attractive option for most parents, grandparents and other relatives. Let’s start by taking a look at some of the “pros” making this one of the better savings options:

  • Unlimited participation; anyone can be an owner and or beneficiary of a 529 Plan
  • No income restrictions; while some options are limited or even unavailable for families that earn more than a pre-determined amount, 529 plans have no such restrictions
  • Flexibility to change the beneficiary to any other member of the family; this becomes very valuable in the event your child receives a scholarship or chooses not to attend college
  • Tax-deferred growth; similar to an IRA, your assets grow tax-deferred
  • Tax-free withdrawals; if used for qualified education expenses, withdrawals are federally tax-free, and in some cases state-tax free as well
  • Potential state-tax deduction for contributions; depending on the state sponsoring the plan, contributions made can be state-tax deductible for the owner of the plan
  • High contribution limits; plans range from lifetime contributions limits of $235,000 to $418,000 depending on the sponsoring state
  • Contribution flexibility; parents, beneficiaries, family or friends can contribute directly to a 529 plan which can be a great way to get your children and family involved in the saving process.

On the other side of things, some of the limited cons to utilizing a 529 College Savings Plan are:

  • Potential tax penalty on earnings if not used for qualified education expenses. Similar to an IRA with distributions before 59 1/2, when distributions are made from a 529 Plan and not used for qualified education expenses, the IRS assesses a 10% penalty tax on any earnings distributed (in addition to ordinary income taxes)
  • Investment risk; the flexibility afforded in choosing your own investments for your 529 Plan can work against you if you suffer losses right before starting distributions, many plans offer age-based options to try and protect against large amounts of volatility close to distribution, but anything invested in the market is always subject to the risk of loss.

In our opinion, the benefits to using a 529 College Savings Plan to prepare for college expenses far outweigh the cons. When working with our clients on their comprehensive financial plan, 529 College Savings Plans are often are primary recommendation when discussing education planning. While we believe strongly in the positive impact of a 529 College Savings Plan, it is important to understand that there are other ways to save. Below is another table that provides some high-level details of those options.

Type of Account Contribution Limits Income Limits Special Tax Treatment
Education Savings Account (ESA) Yes; $2,000 per year Yes; married with income >$110,000 are ineligible Yes; if used for qualified education expenses
UTMA / UGMA None None None
Brokerage Account None None None

 

  • An ESA is unique in that it allows you to use the funds for non-secondary education (private elementary and or high schools), with the major drawbacks being the $2,000 annual contribution limit and low married income limit.
  • UTMA/UGMA have been around for a long time and were at one time the primary vehicle used when saving for or with children. One of the main drawbacks for the custodian (usually the parent), is that when the child reaches the age of majority it is their money and there are no restrictions on how it is to be used.
  • Brokerage Accounts can be useful for high-net worth clients that have fully funded a 529 College Savings Account, but outside of max-funding a 529 plan they are far-less tax-efficient to be considered as a primary savings vehicle for college education.

Conclusion

Balancing the cost of raising a family, saving for your own retirement and saving for your children’s college education can be daunting tasks, but all of these should be considered. We would never suggest that you completely eliminate contributions to your own 401K or IRA to fund college savings. Instead, we attempt to build a plan in which we focus on the best and most efficient way to allocate your savings over the years. While it is a challenge to address all you savings goals, having a sound financial plan, a disciplined savings habit and a trusted partner in HFA helps to give your family the best chance for success.

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