If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan. Stop by HERE for a complete list of classes currently available and HERE for more information about the website.
Class Objectives: To learn about ways to save for and fund higher education costs.
Prerequisites: SA302 Investing Basics: Time Value of Money
Handout: College Saving & Funding Methods
Assignment: Download the estimated college expense cost spreadsheet for Excel | Google Docs
After high school, I had no idea what I wanted to do when I “grew up”, but I did know that I wanted to go to college. I wanted to get away from the tiny town of less than a thousand people where I grew up (yep, I’m a country girl…).
So, I applied to a couple colleges, got accepted, received a scholarship due to my excellent grades in high school and off I went. My parents must have filled out my FAFSA form because that part is a blurry memory. The scholarship covered my tuition, as I went to a very affordable school for my first year. Thank goodness, because I knew I would be covering my living expenses on my own. There was never a conversation about this with my parents, it was just known that this was expected and I got a job as soon as reached campus.
Eventually, I took an accounting class and found my passion. I love numbers and it was just the right fit for me. With a lot of hard work and dedication, I completed a combined Bachelor’s/Master’s degree program that set me on the right path to becoming a CPA. During this time, I only had to take out around $7,500 in student loans for the master’s portion of the program (those crazy graduate tuition rates!) and completed it in less than 5 years. I sometimes worked two jobs, but always had enough to eat and a place to live. Oh, and did I mention that I got married my sophomore year of college and was supporting both of us with my job(s) as well as going to school full-time?
So, with that background, you can see that I’m not overly sympathetic to those that simply take loans out to cover all of their tuition costs as well as living expenses so that they can live the fun college life. I have absolutely nothing against student loans, but I certainly think that current student loan crisis is not only due to rising college education costs, but also insufficient planning and in some cases unwillingness to sacrifice and work hard.
This generation, with its heavy student loan debt burden, is just right to facilitate the change for their own children. They know first-hand the difficulty of beginning their professional lives with high student loan payments and how it feels to be starting behind. That being said, let’s look at some ways to save for a college education (either for yourself or for your dependents).
DETERMINING HOW MUCH YOU NEED TO SAVE
We are going to focus on saving for college expenses, rather than on funding college expenses, but the handout lists other ways to help with college costs. There are a number of great ways to save for higher education, but it all starts with determining how much you will need for college. I’m a huge proponent of setting specific financial goals and that will require you to determine a specific number to save.
First, let’s take a look at college attendance for the current 2016-2017 school year. According to The College Board, average annual tuition at a four-year in-state college is published at $9,650. Room and board will cost an additional $10,440 on average and books & supplies will set you back another $1,250 per year. This totals $21,340 per year for the education costs. These annual costs are summarized along with in-state public colleges and private colleges below.However, there is a significant amount of financial aid available, especially for those with low income. For example, The College Board studies show that families with less than $30,000 in annual income pay no tuition at in-state public four-year colleges. Those with $30,000-$64,999 in income pay a little over 25% of the published tuition rates and those with $65,000-$105,999 in annual income pay about 75%. Even those with over $106,000 in annual income generally do not pay the full published amount.
There are many, many college savings calculators out there. If you want to use an online calculator, I recommend using the American Fund College Saving Calculator. As you know, I prefer to use spreadsheets so that I can update my numbers periodically and always be able to see my detailed inputs and outputs. The spreadsheet for this class is previewed below:
The steps to determine how much you will need to save to fully cover education costs are as follows:
Step 1: Determine future education costs
It’s no small feat to estimate a future college education. The current trend estimates college tuition rising at a rate of around 5% annually, which is significantly higher than the rate of inflation. In contrast, there is also talk surrounding each election about making college education available cost-free to everyone. Your best bet is to plan on covering future education for you or your dependents, especially if you are saving for small children who won’t be attending for another 10 or more years. The spreadsheet shows the calculation based on the age input. The current cost of $20,000 would include tuition and fees as well as room and board at an in-state 4-year public institution. This cost does not include financial aid. So, for this example, the future annual tuition for a child that is currently 8 years old and will begin college in 10 years will be around $32,578 based on a current cost of $20,000.
Your best bet is to plan on covering future education for you or your dependents, especially if you are saving for small children who won’t be attending for another 10 or more years. The spreadsheet shows the calculation based on the age input. The current cost of $20,000 would include tuition and fees as well as room and board at an in-state 4-year public institution. This cost does not include financial aid. So, for this example, the future annual tuition for a child that is currently 8 years old and will begin college in 10 years will be around $32,578 based on the current cost of $20,000.
The next 3 years would be calculated at 105% of the previous year tuition. In this example, the yearly totals would be:
- Year 1: $32,578
- Year 2: $34,208 ($32,578 x 105%)
- Year 3: $35,917 ($34,208 x 105%)
- Year 4: $37,713 ($37,713 x 105%)
- TOTAL: $140,415
You may not want or be able to cover all of these full costs, but understanding how much a college education is likely to cost is a great starting point and also should provide some motivation to start saving now!
Step 2: Determine additional inputs
After determining the education costs, you also need to calculate the current value of your investments and based on your expected investment selection (essentially your risk tolerance), come up with an expected annual return. I’ve used a conservative estimate of 7% average return, which I’ve not adjusted for inflation.
Step 3: Calculate the annual contributions required to meet education needs
After you’ve entered all your inputs, you are ready to do some analysis about the costs you’re planning to cover and the future contributions you’ll make.
Start by entering the college tuition costs as calculated in the first step, even if you don’t think that you’ll be able to cover them in full. Start with age 18 as shown in the example and enter 105% of the previous year’s cost in the next 3 years (use an excel formula to multiply the first year cost by 1.05).
Next, use trial and error to come up with an annual contribution amount that will cover the entire cost of education, including contributing for the first 3 years of college. In the previous example, annual contributions would be required of $6,605 to fully cover the costs. These are definitely significant savings numbers, especially if you have more than one child to save for!
Step 4: Come up with a college savings goal to fit your situation
It’s likely that few people will be able to save over $6,000 per year to cover future tuition for their 8-year-old (but if you can–that’s great and get started now!). Don’t be discouraged. Any money at all saved for college tuition will grow over time and reduce the amount of student loan required to fund the education. I don’t know anyone that wished that they had saved less for college!
Use the spreadsheet to enter the amount of contributions that you can make annually and see how that impacts the ending result. For purposes of simplicity, you can look at the “Ending Balance” to see the remaining costs that wouldn’t be covered by savings.
Set a specific annual goal to save for future college costs for you or your children based on your analysis.
Step 5: Determine the correct savings vehicle to save for education costs
Now you should have an estimate of how much your higher education costs will be in the future as well as a plan for how much you will save annually. The last step is to determine where exactly you should put the money. This is discussed in the next section.
COLLEGE SAVING VEHICLES
Coverdell Education Savings Accounts (CESA)
A Coverdell Education Savings Account was previously referred to as an education IRA. It is similar to other IRA accounts in that there are maximum contribution limits and income limitations. The greatest benefit of a CESA is that it can be used for both primary and secondary education costs.
The contribution limit on a CESA is only $2,000 per year. This is a good start (and better than most to be sure!), however, $2,000 per year is not going to fully cover college tuition so additional options should be considered as well.
Also, contributions are phased out when a couple filing joint has between $190,000-$220,000 in modified adjusted income. Contributions are not deductible for federal or state purposes.
Income grows tax-free and withdrawals are tax-free as long as they are used for education expenses. Another advantage of these accounts is that there are a wider variety of investment options as compared to Section 529 plans.
Some additional things to know about Coverdell ESA accounts are that they can be rolled over to another beneficiary, but if there are still funds in the account when the beneficiary reaches 30 years old, they are required to be distributed and the earnings will be taxed at ordinary rates plus a 10% penalty for not using the funds for qualified education expenses.
A list of the pros and cons of Coverdell ESA accounts is shown below.Section 529 Prepaid Tuition Plan
Section 529 college savings plans are another great way to save for college expenses. There are two types of 529 plans and first, we’ll cover the prepaid tuition plan. This is a state-operated plan that guarantees future tuition at current rates. We talked about how college costs are rising at a rate higher than inflation, so it can make sense to lock in tuition now at a rate slightly higher than current rates to ensure affordability in the future.
Contributions are made to the account and lock in a certain semester or credit hour rate. For example, the Michigan Education Trust plan offers the following options:
- Credit Hour: The current rate for one credit hour is $583 for full benefits (a typical undergraduate degree requires 120 credits so this would total $69,960).
- One Lump Sum: To completely fund 4 years at any Michigan public institution a deposit of $69,880 today would be required (which is very close in amount to funding 120 credit hours as above).
- Monthly Purchase Plans: Michigan offers a variety of payment plans from 4 to 15 years with monthly contribution ranges from $632 to $1,672 (depending on current age of beneficiary) to guarantee tuition rates.
The prepaid tuition plan contributions can be refunded if the beneficiary decides not to attend college, but no interest will be received on the balance. In the case of death or disability, contributions are refunded as well as a small amount of interest (less than 3%).
In many plans, the funds can be used instead for private or out-of-state tuition, but the benefits are substantially less than for in-state tuition.
Only about 10 states currently offer prepaid tuition plans and participation (and offering) is expected to decline in coming years. For most people, it is highly recommended that they participate in the 529 savings plan instead. However, the pros and cons are summarized in the table below.
Section 529 Savings Plan
The other type of Section 529 plan to save for college expenses is a 529 savings plan. Tuition is not guaranteed like the previous plan, but instead you take the risk that your contributions will grow enough to cover the costs of tuition when your child begins college. Amounts in 529 savings plans can be used at any secondary education institutions in the U.S. as well as some foreign institutions. There is a lot more flexibility in contributions and withdrawals, which makes it my top choice for college saving.
First, let’s talk about contributing to a Section 529 plan. There are no set contribution limits to 529 plans and low minimum contribution requirements. Contributions are made with after-tax dollars, but many states offer state tax deductions on contributions up to certain limits. Contributions must be made by December 31st to qualify for any state tax deductions where available.
While there aren’t any contribution limits, each plan has a maximum account balance. Michigan has a maximum balance of $500,000 for each beneficiary (that should cover everything!). Essentially, maximum account balances likely aren’t something that will affect you.
It is also important to note when talking about the contributions that federal gift taxes apply for gifts over $14,000 for 2017. Without going into the details of gift taxes (which we’ll cover in a future class), a married couple can contribute twice that (so $28,000) annually. However, there’s an exception for 529 plans that allows 5 years of contributions to be made in 1 year, referred to as “superfunding”. This allows for $70,000 (single) or $140,000 (married) in contributions for a single year without any federal tax consequences.
One lesser known fact is that you are able to contribute to any state’s 529 plan, even if you aren’t a resident. All 529 plans are not created equal and just like any other investment, results and fees vary. The best comparison out there is at SavingforCollege.com, but it does require a subscription. There’s a 30-day free trial that you can take advantage of in deciding which 529 plan to participate in. They also have rankings that you can look at without a subscription. Just be sure to check whether your own state’s plan offers tax deductions and include that in the basis for your decision as well.
Generally, the basic options offered by 529 savings plans are mutual funds or annuities. Income in a 529 plan grows tax-free and withdrawals are tax-free as long as they are used for qualified education expenses.
Qualified education expenses include:
- Tuition & fees
- Computers and other related equipment required by enrollment
- Limited room & board if at least a half-time student (amount is determined by institution)
If money is used for anything other than qualified education expenses, a 10% penalty applies and the gains are taxed at ordinary income rates. If the account beneficiary receives a scholarship, you can withdraw funds in that amount without penalty or additional tax, however, the earnings portion is subject to federal income tax.
An additional item to note is that there is a lot of flexibility in changing beneficiaries in a 529 savings plan, so if one child doesn’t attend college the money can be used for a different child or family member.
A summary of the pros and cons of 529 savings plan is included in the chart below.
Roth IRA Accounts
Roth IRA’s have become another popular choice for funding college education savings because of their flexibility. Since Roth IRA accounts are funded with post-tax dollars, withdrawals are not subject to income tax. However, it should be noted that there is a rule that requires a Roth IRA account to be open for 5 years (determined by tax years, not calendar years) before withdrawals can be made without the 10% penalty. So the key here (as with all savings) is that if you plan to use a Roth IRA for education, you should open an account as soon as possible to make sure you can meet the 5 year rule.
Contributions to Roth IRA’s are limited to $5,500 annually with an additional $1,000 catch-up contribution allowed for those 50 and over. In addition, income limitations for 2017 start to apply at $118,000 for single taxpayers and $186,000 for married taxpayers filing joint returns. After the full income limitation, contributions are no longer allowed to a Roth IRA (although there are some workarounds for this).
Since the Roth IRA is actually a retirement account, it offers the flexibility of being able to use all the funds for other purposes if your child doesn’t need all the money or doesn’t end up planning to attend college. The money in a Roth IRA grows tax-free and the earnings aren’t subject to income tax if withdrawn after age 59 1/2.
The great advantage of a Roth IRA is that contributions are deemed to be withdrawn first, so withdrawals don’t have to be prorated between your contributions and income earned on them. This allows you to avoid income taxes when withdrawing funds (up to contribution amounts) from the Roth IRA. This puts you in a similar position to the 529 savings plan, but doesn’t limit you to spending the money on higher education.
A summary of the pros and cons of using a Roth IRA for college savings is shown below.
Other Saving Vehicles
There are a variety of other ways that people save for college, which will not be covered in-depth for this class. Some of these vehicles used are:
- Taxable investment accounts
- Series EE & I bonds
- Tax-exempt bonds
- Cash value life insurance
- Certificates of Deposit
These all come with their own set of advantages and disadvantages which can range in investment performance, contribution and distribution availability and other tax benefits and disadvantages. If you have special situations, you may want to consider additional research on other college saving methods.
Although college costs are already high and rising, higher education definitely pays off for the vast majority of people (as long as you actually use your degree to work in your field of study!). It may not feel like it’s paying off if you start out your full-time job with a rent-sized monthly student loan payment, but the numbers show that it most definitely does.
The U.S. Census Bureau published that the 2015 median family income for someone with a Bachelor’s degree or higher is $111,270 while the median income for those with only a high school diploma is less than half that at $52,906.
If you have children or plan to further your education yourself in the future, consider adding college saving to your financial goals and make a plan for saving these funds.
EXAMPLE: THE SMITH FAMILY
The Smith family has two children, both which they are hoping will attend college. Because their income isn’t significantly high (around $75,000-80,000 annually), they determine that they will likely qualify for some financial aid and also plan on some scholarships. They are starting with a base year tuition rate of $15,000. Based on their analysis below, they determine that they would need to save $4,520/year for Emma (age 5) and $3,900/year for Jacob (age 2).
Because they don’t have an extra approximately $700+ per month to fund these costs, they decide to start small by saving $25 per month for each child in a 529 Savings Plan. This will give them the opportunity to save more when they are able in the future and have all of their debt paid off.
Your homework assignment is to estimate and plan for future college education costs using the resources provided in this class.
- IMPROVING -Use an online calculator such as the one at Savingforcollege.com or any major brokerage company to estimate future college education costs for you or your child and make a goal to save for these expenses.
- INVESTED – Use the spreadsheet to analyze future college costs as well as the impact of varying contributions. Start saving now and set a concrete goal for college saving.
- UNSTOPPABLE – Use the spreadsheet to analyze future college costs and contributions as above and research 529 savings plans. Revise your financial goals to include a set number to set aside each month (or year) to save for college expenses.