$2,900 Invested in This ETF Annually Can Send Your Kid to College

Your youngster may be a child prodigy, but it's wise for you to plan for college tuition -- you know, just in case that full scholarship doesn't come through. Sadly, five minutes of research on 529 plans, Coverdell Education Savings Account, and the like is enough to make your head spin. Let's cut through that noise with a simple plan that'll cover four years of college with an annual investment of less than $3,000.

What college will cost

According to U.S. News and World Report, the average annual tuition at a public, in-state school is $9,687 for the 2020-2021 school year. Unfortunately, that number is almost irrelevant unless your kid is already in high school.

In recent years, college tuition has been increasing at a rate of about 5% per year. If you have 15 years before junior heads off to college, that inflation rate would double your annual tuition costs to $20,139. That puts your four-year investment in junior's education at about $87,000.

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Where to save

Many families save to tax-advantaged accounts like a 529 plan or Education Savings Account (ESA). The main advantages of these are that earnings grow on a tax-deferred basis and distributions for qualified education costs are tax-free. But as you might guess, these perks come with restrictions.

For instance, 529 plans have limited investment options and caps on the total allowed account balance. ESAs have an annual contribution cap of $2,000, as well as income limitations on those who contribute. Both accounts are intended to be used for college expenses only. As such, distributions used for other purposes usually incur taxes and steep penalties.

Alternatively, you can save to a low-cost brokerage account and absorb any annual taxes related to dividends and realized gains. You can still take a tax deduction for tuition expenses later, though you probably will end up paying more in taxes this way. The advantage is that you won't have to worry about a plan B if junior decides not to go to college or gets a well-deserved scholarship. A taxable brokerage account also gives you the freedom to invest in whatever you want, which is not the case with a 529 plan.

How to invest

If you invest in a taxable account, you'll want to hold positions that grow by way of share-price appreciation more so than dividends. Dividends are taxable as soon as you receive them, but share-price growth isn't taxable until you sell the position and realize a gain. You'll keep your tax bill low if you buy positions that you can hold up until the tuition bill arrives in the mail. Stocks that don't pay dividends are an option, but an exchange-traded fund, or ETF, which is already diversified, is a simpler solution.

One ETF that's shown strong growth is iShares MSCI USA Momentum Factor ETF (MTUM 2.09%). The fund invests in large and midsize companies that show price momentum. Larger holdings in the portfolio include Tesla, Apple, Amazon, NVIDIA, Adobe, and Google.

In the 12 months prior to October 31, 2020, the fund produced a total return of 19.72%. In the same time period, the S&P 500 grew 9.71%. MTUM pays a quarterly dividend, but the yield is less than 1%.

^SPX data by YCharts.

Saving for college would be far easier if you could count on those 20% returns indefinitely, but that's just not realistic. You can see that from the fund's three-year returns, which are closer to 13%. Plus, it's likely that this fund could underperform the S&P 500 in down markets, which would reduce that growth rate over longer periods of time. A more appropriate growth rate for planning purposes would be 10%, which is still aggressive but not impossible.

Assuming your combined federal and state tax rate is 25%, you'd have to invest $2,900 annually to reach $86,891 after 15 years. That's probably the minimum amount you'd want to save, considering that the projected $87,000 is for tuition only -- meaning no room and board or other college-related costs. So you'll need more than $87,000 if you want the option for your kid to live in the dorms or attend a private school, instead.

The table below shows how different contribution amounts affect your estimated balance after 15 years, assuming that 10% growth rate and 25% combined tax rate.

Table data source: Author calculations

There are a fair number of assumptions baked into these numbers, the biggest one being the double-digit growth rate. For that reason, you can't count on seeing these exact results in your account after 15 years. They could be higher or lower, depending on how the market behaves between now and junior's first day of college.

What you can count on is this: Saving and investing regularly over time will generate wealth momentum. As your balance grows and your financial situation evolves, you can always adjust your plan. Maybe you could even have your child prodigy take over these investing decisions in a few years. You have options, as long as you start saving and investing sooner rather than later.