Guest post written by: Lauren Davidson
Watching college tuition costs continue to soar at a double digit rate must give every parent with aspiring students pause. Is a college education financially out of reach for my children? It’s one thing to look at the cost of college tuition today, which has grown by more than 1,300% in the last four decades; it’s quite another thing to look out 17 or 18 years to see what you might really be up against. The question becomes, in saving for your child’s education, how much is good enough to make it a reality? Here are some things to consider…
Spiraling Costs of College Tuition
The current average cost of college is pegged at $33,500 for private college, $9,650 for state residents at public colleges, and $25,000 for out-of-state students at public colleges. The seemingly practical choice for many parents is to steer their kids to an in-state public school. Just realize that, at the current rate of increase, an in-state public college could cost as much as $41,000 a year. That is a stratospheric number for most American families.
Today an increasing number of families are relying on federal financial aid, which, depending on your financial situation at the time your child is ready to enter college, may or may not be available as needed. Another alternative is to cut your college costs would be to have your child attend a community college for the first two years. But, many parents feel it is important for their child to have the benefit of a complete college experience found at a four-year school. Short of a miraculous reversal in trends, parents have few options in planning for their children’s college education. The one option which can offer the greatest amount of control over the outcome is to save early and save often.
Factors in Your Favor
If you’re looking at this when your child is young, the biggest factor you have working for you is time. When your money is given enough time to work in your favor, it can perform a remarkable feat – and it can compound itself at a fairly fast rate. When money is given the opportunity to earn returns and then have the returns earn returns, the compounding effect is almost magical (hence the phrase: The Magic of Compounding). With any time frame of at least 10 years — the longer the better – your money will have the opportunity to grow exponentially as opposed to incrementally. When tied to a sound investment strategy that can target returns of 6 or 7% or more, you can quickly overcome tuition inflation.
For example, if you start investing $200 a month when your child is one-year old, it will grow to nearly $80,000 with an average return of 7%. If you increase your investment to $300 a month, the compounded returns will grow to more than $110,000, which puts you in the ballpark.
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The second biggest factor in your favor is the tax advantaged college savings vehicles. If you are able to reduce the amount of taxes paid on your investment earnings by 30 to 45% (depending on your combined state and federal tax bracket), you effectively increase your return by the same amount. That creates a higher level of earnings that are able to compound on each other every year.
In addition, qualified college savings plans allow you to access your invested funds tax-free if they are used to pay for eligible college expenses. That means your will go 30 to 45% further in covering college costs.
It is critically important to put both these factors to work for you, optimizing both to give you every advantage available to you. Make the most use of the time you have and maximize your tax-favored contribution to a qualified college savings plan.
Make the Most of a College Savings Plan
As an incentive to encourage parents to save more for their children’s college education, Congress created the 529 College Savings Plan, named after Internal Revenue Code 529 which defines it. Parents can invest after-tax money into the plans, which shield investment earnings from taxes. When the child enters college, the funds may be accessed tax-free as long as they are used for qualified college expenses, which include tuition, fees, books, room and board.
Investing in a 529 plan is similar to investing in a 401(k). The plan typically offers a range of investment options that allow you to allocate your money according to your investment preferences and risk tolerance. If your child is young, less than five or six, you can take a little more risk to try to earn a higher return by investing in growth stock or international stock funds. As your child ages and the time horizon grows shorter, you can adjust your allocation to a more conservative strategy to reduce your exposure to stock market fluctuations.
Each state offers its own versions of the 529 plan. Fees, expenses and investment performance vary from state to state, so it would be important to do you due diligence in studying and comparing your options.
Know How a 529 Plan Affects Your Finances
It is important to know that a 529 plan may impact the availability of financial aid at the time your child enters college. The good news is that, if the parent owns the plan, it will have a minimal effect, reducing the amount of aid by a maximum of $564 for every $10,000 in the plan. The other good news is that the tax-free investment gains earned in the plan should more than offset the loss in aid.
Embarking on a plan to cover your child’s college educations involves several financial strategies that may require the guidance of a financial advisor experienced in college planning. It will be important to look at you entire financial picture if you want to optimize your tax advantages, earnings potential and any financial aid opportunities.
Lauren Davidson is a soon-to-be graduate from the University of Pennsylvania with majors in English and Communications. As she shifts into the “real world” she hopes to start a freelance writing side hustle to help pay down her student loan debt.