A Parent's Guide to Paying for College
In the South, August is typically the back-to-school month. As if you didn’t already have enough to do and worry about, now it’s time to rush to the store, or the web, to get the latest and “coolest” school supplies before they’re all gone. Summer break is ending, which means your weeknights and weekends of relaxing are likely to be filled with after-school or other extra-curricular activities for the kids. While this is likely a stressful time for all the parents out there, there is some good news… You’ll likely save some money on groceries now that your kid(s) and their friends aren’t raiding your pantry all day.
Back-to-School season is also a great time to begin planning for your child’s future education, or review your plan if you’ve already started. If you’re anything like many of our clients, struggling to balance immediate family needs, planning for your retirement, and planning for the future education of your child(ren), you’re not alone. This is where the help of an experienced and trusted financial planner can really be a game changer.
A critical first step in any plan is to determine where you stand. This will obviously be different for everyone, but narrowing down when you want to retire, your lifestyle in retirement, the timeline for college expenses, and other financial obligations can help you prioritize your saving and investing goals to accomplish your objectives. While we recommend a disciplined and percentage-based approach to saving/investing, we understand that not everyone nerds out on numbers like us. The important thing is to find a system that works for you.
Now the real challenge, determining how much to save for college and the optimal strategy. Unfortunately, colleges and universities aren’t immune to inflation, and there are various other factors that cause their prices to fluctuate. To add more complexity, there’s different costs depending on your child(ren)’s chosen college and mode of attendance (online, in-person, etc) and living preference. There’s also an abundance of available grants and scholarships that may or may not be available in the future, making forecasting costs difficult. Oh yeah, and don’t forget about ever-increasing cost of books and other school supplies to add to the challenge.
As a general guideline, we recommend preparing for a 3% annualized increase in cost, and planning to cover 3-4 full years of education expenses. Also, research different scholarships and grants, and apply as early as possible. Ideally, your child(ren) will receive enough assistance to make your contribution easier to manage. You know your child(ren) best, so remember to adjust the plan as needed and review expectations periodically.
Now that we have a rough estimate of the costs, the next step is to create and implement the optimal strategy to accomplish your goals. There are tax-advantaged college savings accounts, various investment accounts, and various saving methods and strategies. Each type of account and strategy has its own unique benefits and drawbacks, so it’s important to determine your optimal fit before diving in.
One popular choice is starting a 529 college savings plan for your child(ren). These state-regulated investment accounts are funded with after-tax money and offer tax-deferred growth. Contributions are not tax-deductible in the current year, but distributions are completely tax-free if used appropriately for qualifying educational expenses. One main drawback to these plans is that they lack flexibility. Since these are intended for education expenses, you could face taxes and penalties if distributions are not used in accordance with the rules. However, as laws continue to change, more preferential methods of withdrawing funds from a 529 plan are emerging. You can learn more about 529 plans in this Saving for College article.
For those of you struggling to prioritize saving for college or saving for retirement, an alternative strategy is to maximize contributions to a Roth IRA, if you meet the income limitations. Roth IRAs are retirement accounts that are funded with after-tax money, similar to a 529 plan. These retirement vehicles offer preferential tax treatment, with funds growing tax-deferred until withdrawn, and withdrawals being federally tax-free when used in compliance with the rules. While primarily for retirement, Roth IRAs do allow the withdrawal of your contributions tax-free for any purpose after a 5-year holding period. This can be a good option if you’re uncertain of your future financial situation, or expect your child(ren) to receive a substantial amount of grants or scholarships, or just don’t end up going to college. However, keep in mind that using this account for education expenses will impact your retirement savings, and an early distribution of gains will likely incur an additional 10% tax penalty.
A more common yet less recommended option is to use a regular savings account to save for future college expenses. While this may seem safe due to FDIC insurance, your money won’t be working as hard for you as it should, and will likely fail to keep up with inflation. This may be suitable if you have a short time horizon before needing the funds, but is typically not the best option for long-term planning. If you do decide to go this route, make sure shop around for the best high-yield savings accounts available. Bank Rate and Nerdwallet are a few good sources of information on high-yield accounts.
Finally, a personal favorite of mine, the regular taxable investment account. This versatile account has no specific restrictions, providing unparalleled flexibility. This account should be included in most financial plans. These can serve as a back-up emergency fund, supplement retirement income, pay for college, various other objectives. There’s no investment limit, but the limited tax benefits basically just include a reduced rate for long-term capital gains and the ability to do some tax-loss harvesting.
Keep in mind, all investments bear some degree of risk, and it’s important to understand and be comfortable with those risks before investing. Of course, there are various strategies available to use within investment accounts depending on your risk tolerance and goals, but we’ll save investment strategies for another discussion. Obviously, this is just a broad overview, and we recommend conducting research and consulting with your financial planner before making any decisions. If you have any questions or need assistance, please don’t hesitate to contact us using the information listed below. You’re also welcome to sign up for our newsletter to receive educational emails.
As you navigate through the complexities of this process, just remember that your child’s education is an investment in their future. The more meticulous the planning and execution, the less likely they are to struggle with the financial hardships and crushing weight of exorbitant student loan debt. While we can’t make any guarantees, having a professional support team can help improve your odds of success, and will greatly reduce the stress of trying to make these decisions alone.