If you follow the news at all, you probably know that a college education has become considerably more expensive over the past few decades. This trend shows no sign of slowing anytime soon, meaning parents might be dreading paying the bill for sending their children to college.
Fortunately, there are strategies you can use to make college more affordable, including tax-advantaged savings plans such as a 529. While you might have heard of a 529, you could be surprised at just how much of a difference it can make.
What is a 529 plan?
A 529 savings plan is an investment account that is similar to a 401(k) in its investment options, and is similar to a Roth IRA in its tax structure.
Like a 401(k), a 529 plan allows you to choose from a basket of investment funds, investing in various types of stocks and bonds. And like a Roth IRA, contributions are not tax deductible, but any withdrawals used to pay for qualified higher-education expenses are not taxed.
529 savings plans are run by the states, and while you don't necessarily need to choose the plan administered by your home state, there could be additional state tax advantages available if you do, so it's definitely worth comparing your options. The maximum contribution limits vary from state to state, but tend to be rather high, exceeding $300,000 in many cases.
Now, if your child doesn't go to college, or doesn't need all the money in the account to pay for college expenses, you can roll over the account to pretty much any relative of the beneficiary, including a sibling, child, parent, or cousin, just to name a few. In other words, if you have more than one child, you can roll over the money from one child's 529 plan to a plan in another child's name.
How much would you need to save?
Now for the fun part. Let's say your 18-year-old child just got into a state university and that his or her tuition and other expenses are estimated to be $50,000 for four years of college. How much would you need to have saved in a 529 plan to cover these expenses?
That depends on when you started. If you began saving when your child was 10 years old, you would need to have set aside about $4,875 per year (roughly $39,000 altogether) to end up with a $50,000 account balance by the student's 18th birthday, assuming 7% annual investment returns. On the other hand, if you started when the child was five, you would have needed to save only $2,500 annually, or just over $32,000 in total.
Here are the required annual and total savings amounts that could get you to $50,000 by your child's 18th birthday.
|If you start saving when your child is...||You need to save (per year)||Total out-of-pocket cost|
|5 years old||$2,482||$32,374|
|10 years old||$4,874||$38,990|
|15 years old||$15,552||$46,658|
Of course, you can always borrow the money
Many parents take out loans to help finance their child's college education, or the child takes out loans. While this is a viable option, and is probably better than not going to college at all, you should know just how expensive this can be.
Let's say you or your child take out $50,000 in student loans to pay for the expenses I mentioned earlier, and that you get a 5% interest rate. If you repay these loans under the standard 10-year plan, you can expect a monthly payment of $530, which means you'll end up paying $63,600.
Or, if you spread the payments over an extended period of time (25 years is the extended repayment period for federal loans), your monthly payment will be a much lower $292, but you'll pay back nearly $88,000 over the life of the loans.
Planning ahead can save you 70%
The point is that the earlier you start taking advantage of the power of a 529 plan, the less your child's education will cost. In the most extreme difference, starting to save for college as soon as your child is born, as opposed to financing that education over an extended period of time, can save you a staggering 70%.
Will your kid's college education be expensive or affordable? A large part of the answer is entirely up to you.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.