One of the great recent tools available for college savings is the 529 plan. This allows you to save money where all gains are tax free, so long as proceeds are used for educational expenses. Additionally, if your state offers a good plan it will frequently make some or all of your contribution a state tax deductible, without any restriction on the school your child wishes to attend. For example, the state of Virginia has given me a tax deduction every year of my kids lives, simply as a thank-you for saving for their education. Over 20 years at a ~5% tax rate, this equates to Virginia providing each of my kids $4000 for their education, and this is in addition to the money I contribute and earn on the investments. Not trivial, and if your state offers a decent plan with tax deductible contributions you should jump on it.
What’s a decent plan? Check if your state offers plans with fees well under 1%, hopefully offering low cost index funds . Even if not, if it’s offering a tax deduction there is still a chance it’s your best option. If not, there are several articles on other state’s plans (which you are able to join even if not in that state), a good reference is here. Many of the plans offer an automatically adjusting asset allocation as your child gets older, which I find convenient and forces discipline for asset allocation.
Alternatively, there are pre-paid plans where you pay today’s tuition prices to an in-state school for attendance later, but these are not my preference. These plans offer less flexibility for your child for school choice and only offer an effective rate of return equal to the rate of annual tuition increases for that school Although this rate of inflation is high compared to normal increases of other things we buy (see below), hopefully it still should be outpaced by the return you should get from a bundle of low-cost mutual funds.
How much to save is a tough question with a lot of variables, and you are unlikely to get help by asking your infant or toddler if they are thinking community college or Ivy League, but I have a suggestion for a reasonable approach:
- Start the 529 plan as soon as possible, preferably right after your child is born. Tell all proud grandparents the account is open! Maybe a blatant cash grab, but $50 in their account will be way more valuable to everyone involved than a designer little outfit that the little one will outgrow in a week. After he or she has spit up on it.
- As a benchmark, look at your state university tuition, room, and board costs today. Then look at the average inflation rate of these things over the past 20 years. You can find all of this online. This might shock you, I’ve used a number of at least 5% and historical numbers are often even higher, well above normal inflation. Doing this, you can take a good guess at what the expense will be for your child when he or she gets there. For example, if the candidate university for your newborn is currently $30K for tuition, room, and board, the suggested targeted expense is:
Year 1 = (1.05)18 x $20,000 = $48,000
Year 2 = (1.05)19 x $20,000 = $51,000
Year 3 = (1.05)20 x $20,000 = $53,000
Year 4 = (1.05)21 x $20,000 = $56,000
$208,000
That bottom line number is a big ouch, but remember this ignores things like scholarships and other financial aid, this is just a guide to give you a feel for the costs of college.
- The best way to attack a big number is like attacking a whole pizza: small bites. I suggest you make regular monthly savings contributions and assume a reasonable rate of return of 7% and contributions for 22 years. Using the PMT feature in Excel this is=PMT(.07,22,-208000)/12 = $1570 per month. Again, ouch, but this is just your target. Each year you’ll be able to look at your actual balance and the new projected tuition (based on the updated numbers) and recalculate your month goal. And you can make adjustments, like your child has recently developed some massive athletic skills, or suddenly takes a liking to that high priced private school.
Your saving for college doesn’t have to be perfect, and if you fall short there is financial aid of all kinds. But it is important to get an idea of what the college costs could be and to use the power of compounding to start right away.
One last editorial note. College tuition is like any other purchase, and you should approach it based on what you can afford, not just what you want. Just because you want a Mercedes, you might only be able to afford a used Honda (and truthfully, that used Honda will likely serve you just as well). For some reason, we tend to throw that decision making out the window when it comes to college. We pick one, and borrow whatever shortfall is needed. (Side note, this may be partially to blame for why college tuition is escalating far more quickly than other things in the economy, lack of demand by the consumer for prices to be kept to affordability). Student loan debt is a popular issue right now, and the hole that some young people have when they are just getting started is staggering. If you graduate with six figures in student loan debt, likely you picked the wrong school. The community college in my state is less than $6000 per year for tuition, without any financial aid. State universities are about twice that. So 2 years in community college and two years at a state school is less than $40k. Assuming you have saved $0 and get $0 in aid. I know you might not want to go to community college, but there is zero wrong with that education (teaching can actually be superior here) and that might be what you can afford. There is a misconception that if instead you go to a fancier private school, whose tuition is close to $60k per year, clearly you most be getting a massive advantage over everyone else. Well, maybe, but largely college is what you put in to it, and the student from State U at today’s tuition rates has a $200,000+ head start. OK, off my soapbox. If you really want your young one to have maximum college choice, the calculations above can give you a guide–and just so you’re aware, for the priciest private schools, and adding in room and board, that is a projected total of over $700,000. Yeah.