Currently, the outstanding student loan debt in America is $1.6 trillion, with the average student loan debt at $32,731. It makes student loans the second-highest consumer debt, just behind mortgage debt. It even outpaces credit card debt and auto loans.
It begs the question, is there a way students can get a higher education without incurring student loans? The answer is generally yes, but you should also consider alternatives to college.
As a parent and student, you should not feel you are at the mercy of student loans. You can get a higher education without racking up colossal amounts of student debt. How do you do this?
This article is going to show you how to save for college and avoid getting into student debts. Let’s dive in.
When should you start saving for college?
The best time to start saving for college for your child is as soon as they are born. However, for many parents, this is never the case.
The other best time to start saving for your kids’ college is when you have paid off all your debt (credit card debt, auto loan, and student loan), and are only remaining with your mortgage.
Also, before you start saving for your kids’ college, you should have an emergency fund that can cover at least 3-6 months of your living expenses, and you should be saving 15% of your income towards retirement. Once you have ticked these boxes, you can start saving for your kids’ college.
How Much to Save for College
It may be daunting thinking of how much you need to save to cover a 4-year college education. For example, if you are aiming to take your child to a top-private college with an average of $50,000 school fees annually, you will need to save about $200,000 for your child. It is exclusive of living expenses, books, supplies, and other expenses. You can comfortably say college is like taking a small mortgage without owning a home. Is there a way out? Yes, there is.
The rule of thumb is to save for a third of the anticipating college costs. It is because people rarely pay for massive expenses in one lump sum. Most expenses at any time are covered with current income, savings, or loans. By saving at least a third of the college fund, you will incur fewer loans, and you can use other methods to supplement the shortfall, which will discuss later.
You should also factor for inflation of college costs. Data shows the cost of college education triples every 18 years, with an average inflation rate of 6.6%. So, if your child is born today, and the current price of a 4-year college degree is $200,000, when they turn 18, the cost of the same degree will be $600,000. If you are to save, you should then save the full cost of college as when your child is born. That is about $200,000 with the above example.
How to start a college fund
There are various ways you can save for college. These different methods have their pros and cons, and it will be up to you to decide which method best fits your needs. Here are some of the ways you can use to save for college.
1) 529 College Savings plan
Named after Section 529 of the IRS tax code, 529 plan is a tax-free college saving plan designed by the state government to help families save for their kids’ future education costs. It operates similarly like a 401(k) or IRA account.
The beauty with a 529 is that it can be used in any learning institution, unlike before, when it was limited to college education alone. On top of that, anyone can contribute to it (so grandma can chip in), and you can change the beneficiary of the plan. So, if the beneficiary child does not want to go to college, you can transfer it to your other child, a niece, nephew, or even yourself.
When you go shopping for a 529 plan, make sure the plan has low fees, and it does not freeze your money or automatically change your investments once they mature. It will ensure you have options with your plan.
How much do you contribute?
How much you can put, in your 529 plan, is subject to the federal gift tax limit of $15,000 per person. However, the 529 IRS code makes an exception, and you can front-load your plan with $75,000, which is 5 years’ worth of federal gift tax.
So, how much can you put in total in a 529? The limit of the account is subject to the laws of each state. However, the cap is mainly on how much a student needs for a college education.
In states like California, Newyork, Pennsylvania, District of Columbia, Idaho, Louisiana, Maine, Maryland, Michigan, Nevada, New Hampshire, New Mexico, South Carolina, Virginia, Washington have high aggregate limits of about $500,000. While states like Missouri, New Jersey, Hawaii, Connecticut, have low aggregate limits of about $300,000.
Pros of a 529 plan
- The plan grows tax-free
- There are various age-based options, and it’s never too late to invest in one.
- State income tax deduction is available (*subject to state laws)
- Highly flexible and can be transferred to another beneficiary
- High contribution rate, ranging from $300,000 to as high as $500,000 (*subject to state)
- They are available to every household despite their household income or the amount they contribute
- The beneficiary is eligible for financial aid
- Low maintenance, you can set and forget about it
Cons of a 529 plan
- Funds can only be used for education
- There is a tax on your gains and a 10% federal penalty if you withdraw the funds for non-education expenses
- Advisor sold 529 plans have high fees
- 529 plans owned by a third party, for example, a grandparent can hurt the beneficiary chances for financial aid eligibility
- There is a limit on state tax benefits
2) 529 Prepaid Tuition Plan
Unlike the 529 where you save for tuition, a 529 prepaid tuition plan allows you to pay tuition for a student at current market rates for future education. To benefit from this plan, you have to take it up 3 years before use, and the beneficiary should be 15 years old or younger.
However, these plans are rare, and many states that used to offer them have ceased. Owning to the fact that tuition fees are increasing at a much higher rate than other sectors of the economy, and many states are not willing to bear the risk. On average, college tuition is increasing 3 times higher than the consumer price index.
Currently, 18 states are offering prepaid tuition plans, and only 9 out of these are accepting new applications.
These are Florida, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, and Washington.
Out of these states only, Massachusetts, Mississippi, and Washington have a guarantee on the funds contributed. The other states do not have guarantees, and the funds are back by the assets in the fund. In case the fund goes kaput, states promise that their legislature will budget for the money needed to pay out benefits, and it is not a guarantee.
Other than states, there is one institution sponsored 529 prepaid tuition plan, (Private College 529 Plan), which has about 300 private colleges and universities participating in the 529 prepaid tuition plan. The institution has a diverse pool of universities, from top-ranked national colleges to regional institutions.
How does a 529 prepaid tuition plan work?
Just like a 529, money put in a 529 prepaid tuition plan grows tax-free and is tax-exempt for qualified education expenses. It has a high maximum contribution aggregate, and deposits of $15,000 per year per individual are possible with the plan. It also qualifies for the 5 years $75,000 federal gift tax front-loading.
Another similarity, with the 529, is that it can be transferred to another beneficiary. In some cases, it can be transferred to another school or state if the beneficiary chooses to change schools.
Lastly, some 529 prepaid tuition plans are only open to state residents, while others are open to non-residents. Therefore, do your research to know which is which.
Pros of a 529 Prepaid Tuition Plan
- The plan grows tax-free
- It is a good plan if both the parent and student are sure of their higher education plans
- You can lock down future tuition at today’s price
- It can be transferred to members of the same household
- The Private College 529 Plan does not have a state residency requirement
Cons of a 529 Prepaid Tuition Plan
- They do not cover as many costs and are usually limited to tuition and fees
- Apart from Massachusetts U.Plan Prepaid Tuition Program, all the other state-sponsored 529 prepaid tuition plans are limited to residents
- State plans are only available on set months of the year, for example, Florida’s Prepaid Plan has its enrollment from October through February
- Not all states guarantee prepaid plans. Michigan, Nevada, Illinois, Pennsylvania, and Texas do not have a guarantee and can stop or change their plans at any time.
- They are only available for in-state public colleges/universities
- They are subject to state and federal income tax and a 10% penalty if funds are not used for qualified education expenses
3) Coverdell Education Savings Accounts
Formerly known as the Education IRA, Coverdell Education Savings Account works just like a 529 plan. It is a trust or custodial account for paying qualified education expenses for the beneficiary of the account. The advantage of this account is that it does not only cover higher education, but it also covers elementary and secondary expenses.
It offers tax-free investment growth and tax-free qualified education expenses. However, tax-free withdrawals are limited to $10,000 in tuition expenses for K-12 schools. But it qualifies elementary and secondary education expenses like books, supplies, equipment, academic tutoring, and special needs services in connection with enrollment or attendance at an eligible school.
Coverdell ESAs have a low maximum contribution per child with a total contribution to this account that cannot exceed $2000. It is only available to families with a modified adjusted gross income of less than $110,000 ($220,000 for couples filing a joint tax return). Friends, family, and grandparents can contribute to a Coverdell ESA if they also meet this income threshold.
Once the beneficiary turns 18, you cannot contribute to a Coverdell account unless the child has special needs.
Pros of a Coverdell Education Savings Account
- Contributions grow tax-free and qualified educations expenses are tax-free.
- It allows more withdraws per year for qualified educational expenses unlike the other plans
- It is a smart option of saving for education if you meet the income requirements
- It is a desirable option if you have many children and you want them to attend college
- It covers elementary, middle, and high school education unlike other 529 plans
- Unlike the other 592 plans, with a Coverdell ESA, the investment is self-directed. As a parent, you can choose to invest the funds the way you deem fit, be it in stocks, bonds, mutual funds, or CDs. Simply, the way you see you will have the most growth during the lifetime of the investment
Cons of a Coverdell Education Savings Account
- It has income restrictions, and as your income increases how much you can contribute to the account decreases
- Contributions can only be made up until the 18th birthday of the beneficiary and cannot go beyond this time limit
- It may affect how much a beneficiary receives in terms of financial aid.
- In the event funds are not used by the time the beneficiary turns 30, the account will be charged income tax and a 10% federal penalty.
Conclusion
A college education is becoming more expensive by the day. Like we saw at the beginning of this article, American college graduates cross the stage with an average of $32,731 in debt.
As a result, it is affecting people’s life milestones like getting married, starting families, owning homes, buying a car, and even starting a small business. Furthermore, it is compounds mental health issues faced by young adults.
It, therefore, makes sense to plan for college and avoid getting into debt or having as little debt as possible. And with the above strategies, it is possible to save for college and not have to incur student loans to get a college education.
Author: Hilda Munjuri is a freelance personal finance writer. She enjoys finding new money hacks and investing. Her dream is everyone achieves financial freedom in their lifetime.
