Providing for children's education is a common financial goal, especially for young families. In this post we explore (1) how to set a realistic savings goal and (2) education savings accounts that offer unique benefits for college savers.
Step by Step: How Much to Save for College
1. Decide What "Saving for College" Means to You
“Paying for college” is a broad goal that can mean very different things to different people. The cost of a college education varies significantly when considering private vs. public institutions, 2-year vs. 4-year degrees, tuition vs. room and board, undergraduate vs. graduate degrees, and more.
Your first step in saving for college is to identify what type of higher education you want to provide for your children.
For example, you may want to provide tuition and room and board at a 4-year state college. Or you may want to be able to provide for the same expenses at a private university.
Make sure you and your partner are on the same page when you say you want to “pay for college” for your kids.
2. Estimate Education Cost
We don’t know what education expenses will be in 20 years. However, very similar to how we estimate retirement spending, we can use current education costs as a starting point.
After deciding what “saving for college” means for you in step 1, research the current costs of those expenses.
For example, if you want to provide full tuition, room and board, and ancillary expenses for a state college, go to your state’s university system to review current costs.
Searching for current costs in Wisconsin, I can find the following through the University of Wisconsin’s financial aid website. The total annual cost of attendance for a Wisconsin resident is estimated to be $27,920 in the 2022-2023 school year.
If you have private college or a specific alma mater in mind, you can go directly to the university website for this same information.
3. Estimate Education Cost Inflation
Although college costs are nowhere near the relatively low tuition rates of the 70s or 80s, the most dramatic college price changes occurred in the 2000-2010 decade. Education cost increases have slowed dramatically since 2010.
Per CollegeBoard, inflation-adjusted tuition and fees for a four-year public education increased 38% from 1991 to 2001, 73% from 2001 to 2011, and only 9% from 2011 to 2021.
While college is not getting cheaper, costs are not increasing anywhere near the rate of the first decade of the 2000s.
If you expect this trend to continue, this means a roughly 1% annual education inflation rate above general inflation. So if you expect inflation around 2%-3%, you may assume 3%-4% education inflation.
4. Calculate Education Savings Goal
Given the current cost of your education savings goal (step 2) and estimated education inflation (step 3), you can calculate your savings goal using a financial calculator.
For example, assume you are a Wisconsin resident, want to provide for a 4-year degree at a state university (4 years of $27,920 = $111,680), a 3% education inflation rate, and 15 years until your child enters college. Roughly $174,000 would be your total savings goal.
5. Calculate Annual Savings Target
Using another financial calculator, you can identify an annual savings target to reach your goal.
Assuming a $174,000 goal in 15 years, $10,000 already saved, and a 6% nominal rate of return, your annual savings target would be approximately $6,000.
6. Assess Tax-Advantaged Account Options
Given your education savings goal, review tax-advantaged accounts to reach your goal more efficiently.
Although you can save for education expenses in a taxable brokerage account, certain account types offer advantages like state tax deductions and tax-free growth.
Education Savings Accounts
A few different account types are available for college savings, with their own advantages and disadvantages. Differences among the accounts include control over the funds, investment options, flexibility in using the funds, and more.
529 accounts tend to be the most attractive option for most savers, but we will explore some alternatives too.
Below is a summary of the accounts and their features, followed by an in-depth look at each account.
1. 529 Plans
529 plan accounts offer tax-free growth for your college savings, so long as the funds are used for qualified educational expenses.
529 accounts have an owner and a beneficiary.
The owner is who sets up the account and controls the beneficiaries, investments, and distributions. This is often a parent but could also be a grandparent or loved one.
The beneficiary is who eventually benefits from the account, often a child. The account owner can change the beneficiary at any time, although there are certain restrictions on changing the beneficiary outside of the family.
Annual contributions are generally limited by the gift tax, $16,000 per beneficiary in 2022 (and $32,000 for married couples).
However, for 529 plans parents and grandparents are eligible for five-year frontloading. Five-year frontloading 529 plans allows you to contribute up to 5 years of the gift tax limit without incurring gift taxes or reducing the lifetime gift tax exclusion.
There are no federal tax deductions for 529 plan contributions, but certain states provide income tax deductions.
Investment growth is tax-free so long as withdrawals are made for qualified education expenses.
Non-qualified withdrawals are subject to taxes on investment earnings, plus an additional 10% penalty.
Qualified Education Expenses
Qualified education expenses include far more than college tuition. Qualifying expenses include college tuition, room and board, books and supplies, computers, and more. K-12 tuition also qualifies up to $10,000 per year in 2022.
Student loans also qualify up to a lifetime limit of $10,000.
2. Coverdell Education Savings Accounts (ESAs)
Coverdell ESAs are very similar to 529 accounts, but with far lower annual contribution limits and restrictions on contributions above certain income levels. For these reasons, 529 accounts are often preferred to Coverdell ESAs.
Similar to a 529 plan, a Coverdell ESA has an owner and a beneficiary.
The account owner controls the account. The beneficiary receives withdrawals for qualifying education expenses.
However, different from a 529 account, any balance remaining once the beneficiary turns 30 is distributed to the beneficiary. The beneficiary of a Coverdell ESA can be changed prior to age 30.
Coverdell ESA contributions are limited to $2,000 per year per beneficiary.
Contributions are only allowed if your modified adjusted gross income (AGI) falls below certain thresholds. Single filers must have a modified AGI less than $95,000, $190,000 for married filing jointly.
No federal or state deductions are offered for contributions to a Coverdell ESA.
Earnings grow tax-free for qualified education expenses. Earnings withdrawn for non-qualified expenses are subject to taxes and a 10% penalty.
UTMA (Uniform Transfer to Minors Act) and UGMA (Uniform Gift to Minors Act) accounts allow individuals to give or transfer assets to minor beneficiaries. The accounts are managed by an adult custodian until the minor becomes of age.
These accounts do not offer tax incentives specific to education costs, but offer flexibility in how the funds can be used.
Gifts into an UTMA/UGMA account are irrevocable and are managed by an adult custodian until the minor reaches the age of majority. The age of majority ranges from 18-21 and varies by state.
Funds in the UTMA/UGMA account can be used for the benefit of the child. Different from 529 accounts and Coverdell ESAs, distributions do not need to be for qualified education expenses.
There are no limits on contributions to an UTMA/UGMA account, but amounts above the annual gift tax limit must be reported to the IRS.
UTMA/UGMA accounts do not offer tax deductions or tax-free growth for qualified education expenses.
UTMA/UGMA accounts are subject to the "kiddie tax." This tax applies to dependent children under the age of 18, or full-time students under age 24. Unearned income (like dividends, interest, capital gains from an UTMA/UGMA account) is not taxed up to $1,150, the next $1,150 is taxed at the minor's marginal tax rate, and anything above these amounts ($2,300) is taxed as income for the parents.
4. Taxable Brokerage Accounts
Although taxable brokerage accounts do not offer tax advantages for education savings, they are a viable option for your college savings. These accounts offer the greatest flexibility for your savings at the cost of no tax incentives.
The owner of a taxable brokerage account retains full control. There are no beneficiaries for whom distributions must be made to benefit.
Taxable brokerage accounts are not subject to contribution or income limits.
Investment earnings (dividends, interest, capital gains) are taxable to the account owner.
Your College Savings Plan
Saving for college can seem daunting amid headlines of rising education costs and student loans. But even if you cannot save as much as you would like today, every contribution to your child's 529 plan helps and is a wonderful gift for their future.
As with all of your long-term financial goals, it's important to reassess your assumptions on a regular basis and adjust as necessary. College costs, inflation, investment returns, and your child's career aspirations are constantly evolving.