Here is a scary statistic – The class of 2013 graduated with an average of $35,200 in college related debt. OK, that’s a bit better than I thought. I have heard even worse stories of kids who owe much more than that and are unemployed. My brother owed over $100,000 when he graduated and it’s hard to get going when you start out in a hole. (He’s a doctor though so I’m sure he’s doing fine.) My parents paid for my college education and we really want to do the same for RB40 Jr. That will be our legacy to him as we are not planning to leave much if any inheritance. I think the best gift you can give your child is a good education.
How much college will cost
Oh man, this is going to be a shocker to all the parents who haven’t looked into this yet. According to the College Board, the cost of higher education has been rising at about 6% annually. College is already expensive and 6% increase per year is kicking it into the stratosphere.
We’ll use savingforcollege.com’s online college cost calculator.
The following are needed to get started. .
- How old is your child? 2 years old
- Will be attending a college that currently costs $32,000 annually. I’m using the current instate cost from our alma mater, UCSB. You can look up your kid’s future college at the National Center for Education Statistic.
- Will attend college for 4 years on a full time basis.
Here is the result
100% of your total college costs will be $355,618.
Yikes! That’s more than what our home is worth. We already started saving for his education, but I’m not sure if we can reach that amount in 16 years.
What is the 529 plan?
One way to save for college is through the tax-advantaged 529 plan. Each state has a different 529 plan and you can invest in any state’s plan. There are two types of 529 plans, prepaid and savings plan. The prepaid plans allow you to pay tuition at the current price and attend in the future. The saving plans invest in stock and bond funds. I don’t really like the prepaid plans because we have no idea where the kid will eventually ends up. The saving plan is much more flexible.
Pros of 529 plans
As mentioned above, there are tax advantages if you invest in the 529 plans.
State tax benefit – Many states provide state income tax deduction for the contribution (up to $4,455 by a married Oregonian couple filing jointly.) That’s 9 to 10% tax deduction for us. You can check your state’s 529 tax benefit here.
Federal tax benefit – The distribution for the beneficiary’s college costs are tax free. Assuming the government doesn’t change the law.
Automatic option – You can set up automatic deduction so you don’t have to worry about it. Many states have age-based funds which will allocate your fund according to when the beneficiary turns 18 and is expected to enter college.
Transferable – If RB40 Jr. declines to go to college, then we can transfer that fund to other qualified members in our family. Perhaps Mrs. RB40 can finally work on her Ph.D.
Estate plan – This one is for the grandparents out there who want to help out. They can contribute up to $14,000 ($28,000 for married couples) per beneficiary tax free every year. This is a great way to pass money down to future generations without paying taxes while retaining control of the fund.
Financial aid calculation – 529 saving accounts in your name is treated as the parent’s asset. This is good news because only 5.6 percent (or less) of the 529 is used in the expected contribution toward your child’s college cost. Student’s assets are computed at 20% in the financial aid formula.
Disclaimer: Talk to your tax professional when you withdraw or contribute a large amount to make sure you don’t run into any unexpected problems.
Cons of 529
Limited investments – Generally, there is only a few investment choices in the 529 plan. The Oregon plan has U.S. equity, International Equity, Social Choice (socially-conscious funds – seem very Portlandia from the name), inflation-linked Bond, Bond Index, and Money Market. We can also use the age-based portfolios and target allocation portfolios.
Reallocate once a year – You can only reallocate once per year in the 529 plan.
Penalty – The earning portion of money withdrawn from the 529 that is not spent on college expenses will be taxed at the normal rate, an additional 10% federal tax penalty will be assessed, and there is the possible recapture of any state tax deduction. An exception to the 10% penalty can be claimed if the beneficiary has passed away or if the fund is not needed because he has received a scholarship.
529 college saving plans are a great way to save
Generally, I think everyone should max out their retirement contribution first and then contribute to the 529. Your 401(k) and Roth IRA provide great tax benefits and you may not have to pay the 10% early withdrawal penalty if you take money out to pay for college.
I also think it’s a good idea to front load the 529 to maximize the compound benefit. If you put in $70,000 early on, it will earn much more than if you spread it out over 18 years. The earnings will be tax free so it’s best to get rolling ASAP. The earlier you invest, the longer your fund has to compound.
- If you save $70,000 when your kid is born, you’ll accumulate $294,040 (assuming 8% annual gain.) That’s $224,000 tax free!
- If you spread it out over 18 years and save $324/month until your kid is 18, then you’ll have $156,585. It’s still good, but probably won’t be enough to pay for 4 years of college.
The only caveat is to make sure not to go over the $14,000/year gift limit. For the 529, you can contribute $70,000 in one year and treat it as if you were contributing the lump sum over five years.
Unfortunately, we don’t have $70,000 sitting around. We are planning to contribute about $10,000 per year until he’s 5, and then step down a bit after that. Currently we have a little over $30,000 in the 529 with 16 years left to go.
Our goal is to pay for 4 years of instate public college. If he wants to go to graduate school or attend a private college, then he will probably have to take out some loans.
*Tax shield – One reader mentioned that 529s could be valuable as tax shields even without any intention of using them to pay for education. I can’t find any way to do this (without paying the penalty) from my research. If you know some way to do this, please share.