Given the rising cost of college in the U.S. and the many different ways you can save, saving for college can seem intimidating. However, it can be far easier than you'd expect if you know the best types of college savings accounts, how to invest your child's college fund, and how to automate the process.
With that in mind, here's a quick guide to help you get all three of those things right and make the college savings process easier than you ever thought possible.
Use a tax-advantaged savings vehicle
While Americans aren't doing a great job of saving money overall, college savings is a big exception. In fact, 6 out of every 10 parents in the U.S. are actively saving for their kids' college costs.
That said, there's room for improvement in where they're saving, as 30% of parents save for college in a standard checking or savings account, earning little or no returns on their money, according to a Sallie Mae report. Others use standard, taxable brokerage accounts and are thereby missing out on major tax savings.
The first step in accelerating your efforts to save for college is to choose a tax-advantaged savings vehicle. There are two such accounts designed specifically for college savings: the 529 savings plan and the Coverdell Education Savings Account. Roth IRAs can also make sense for some people. Here's a rundown of the basics of each of these options.
529 savings plan: These accounts are run by the states and are similar to a 401(k) plan. You deposit money into a 529 savings plan and can choose from a menu of investment options. Some of these are automated portfolios, designed for children of a specific age, while there may also be some non-age-based investment funds to select. Not only are withdrawals from 529 savings plans 100% tax-free when used for qualified education expenses, but in many states, contributors can deduct their 529 deposits on their state tax return. 529 savings plans have high contribution limits, with many plans allowing lifetime account contributions of $400,000 or more.
Coverdell Education Savings Account (Coverdell ESA): A Coverdell ESA allows contributions to be invested in virtually any stock, bond, or mutual fund, making it a good choice for savers who want maximum control over how their child's college savings are invested. For example, if you want to invest some of your child's college fund in Apple stock, a Coverdell ESA allows you to do it. Contributions to Coverdell ESAs are never tax-deductible, but as with 529 savings plans, withdrawals for qualifying expenses are 100% tax-free. The main downside to Coverdell ESAs is that the contribution limit is rather small -- just $2,000 per year, per student.
Roth IRA: Primarily designed as a retirement account, a Roth IRA can also make a smart college savings vehicle. The tax structure of a Roth IRA is similar to a Coverdell ESA's: Contributions aren't tax-deductible, but qualifying withdrawals are 100% tax-free. Ordinarily, Roth IRA accountholders can't withdraw any earnings before age 59 1/2 without incurring a 10% on the amount distributed. However, there's an exception to the early-withdrawal penalty. So long as the account has been open for at least five years, withdrawals that go toward qualifying higher-education expenses will be not only tax-free, but penalty-free as well. In a nutshell, a Roth IRA can be a smart choice for parents who want the option to use the money for their retirement in the event it's not all needed for college expenses.
Invest your money the right way
Once you've chosen the right savings vehicle, the next step is to invest your child's college savings properly.
My rule of thumb is to treat your child's college savings in a similar manner to how you would treat your own retirement savings: Invest somewhat aggressively when they're young and still have a while until they're in college, and gradually shift to more conservative investments as they get closer to college age.
If you're investing in a 529 savings plan, there's probably an investment option that will make this gradual change in allocation for you. There may also be age-based investment options that you can change over time. For example, my daughter's college savings are invested in a 529 plan's "0-3-year-old" investment option, which is a more aggressive, stock-heavy investment mix. Next year, when she turns four, I'll shift her portfolio to the "4-6-year-old" option, which is slightly less aggressive.
If you have a Coverdell ESA or Roth IRA, my suggestion would be to start out with an allocation of mostly stocks (or stock-based mutual funds and ETFs). For example, if your child is just a few years old, a 90% stock/10% bond allocation would be appropriate. As your child gets older, gradually shift some of the stock allocation to fixed-income investments such as bonds, and eventually some cash-equivalents like Treasury bills and money market funds. For example, the "18 year and older" option in my state's 529 savings plan consists of 10% equity (stock) investments, 50% bonds, and 40% cash and equivalents, so that would be a good mix to aim for over time.
Make the process automatic
If you've opened a tax-advantaged account to help you save for college and developed an investment plan that maximizes your return potential, then you're miles ahead of the average college saver.
However, there's another important move that will not only help you achieve your savings goals, but also make the whole process easier: automate your contributions. In other words, decide how much you want to contribute to your child's account every time you get paid (or every month, or every quarter -- whatever frequency works best for you). Then set up automatic transfers from your bank account to the college savings account at regular intervals.
For example, let's say you want to put $3,000 into a 529 savings plan each year, and you get paid biweekly. By setting up an automatic $115 transfer ($3,000 divided by 26 pay periods) every two weeks, you'll give yourself a much higher chance of success than you could by contributing money here and there. By doing this, not only will you effectively force yourself to contribute, rather than spending the money, but you'll ensure that you're investing with the long term in mind and not reacting to stock market panics or making other emotion-driven decisions.
The bottom line on college savings
To recap, while no two college saving situations are identical, there's a general three-step approach that can make the process much easier than you think:
- Choose the tax-advantaged college savings account type that best meets your needs
- Create an age-appropriate investment strategy for the money you put into the account
- Make the process automatic
If you do these three things, not only will it make saving for college easier, but it'll put your savings in the best position to safely grow and compound in the years between now and when your child is ready to head to college.