Episode 101: Back to School, Back to College Savings
In this episode we discuss all things college savings
Transcript
Hello and Welcome to the balanced Wealth Podcast.
My name is Jarret Topel. As summer winds down and the kids head back to school, there is a shift in the air. And, as my kids said on Monday, ‘But I don’t wanna go back!’ And honestly, I get it. Going back to school is a big transition for everyone — kids, parents, and even grandparents. But as the backpacks get heavier and the schedules fill up, it is also the perfect time for families to pause and think about another big question: how to prepare for the cost of college.”
It is no secret that the cost of higher education has been rising steadily year after year, consistently outpacing inflation. Over the past two decades, tuition at many colleges has more than doubled, and that doesn’t even include room, board, books, and beer money. The good news is that you have options. In fact, there are several effective ways to save for a child’s education, each with its own benefits, potential tax advantages, and considerations.
In today’s episode, were going to take a brief look at a few of the more popular college savings strategies, to help you decide which plan of action, or combination of plans, makes the most sense for your family. And first, let’s begin with why starting now — wherever you are in the process — can have a significant impact. If your child is ten years old and you begin saving $200 per month in an account earning an average of six percent annually, by the time they are eighteen, you will have about $24,000.
If instead you had started when they were five years old, that total would be closer to $45,000. And if you had been able to start when they were born, you would have accumulated around $74,000. The difference is entirely due to the extra years of compounding — the earlier you start, the more time your money has to grow.
And, even if your child is already in high school and college is just a few years away, it is still worth starting. Every dollar you save now is one less dollar borrowed later. Reducing the need for student loans can make a meaningful difference in your child’s life after graduation. Both financially and emotionally.
So, now, let’s talk about different ways to save for college. And, let’s start with the account that is often considered the gold standard for education savings: the 529 plan. A 529 plan is a tax-advantaged investment account designed specifically for education expenses. In CA, you contribute after-tax dollars. Some other states have some limited stat tax-deductions available for 529plan contributions, but not CA. Those contributions grow tax-deferred, and withdrawals are completely tax-free as long as they are used for qualified education expenses. Qualified expenses include tuition, fees, room and board, textbooks, and even certain technology costs like a required laptop.
Contribution limits vary by state, but most states allow lifetime contributions of at least $300,000 per beneficiary, with some state limits exceeding $500,000. In recent years, the rules around 529 plans have expanded, and now you can use up to $10,000 per year for K–12 tuition and up to $10,000 in total to repay qualified student loans. Starting in 2024, new provisions also allow a limited amount of unused funds to be rolled into a Roth IRA for the beneficiary, under certain conditions, providing even more flexibility.
While the benefits of a 529 plan are significant, there are also some limitations to consider. If you withdraw funds for non-education purposes, you will owe income tax on any gains and a ten percent federal penalty, and possibly also a state tax penalty, on the earnings portion of the withdrawal. Additionally, investment choices are limited to the funds offered within your chosen plan. So, sorry, no you cannot buy Invidia stock in a 529 plan.
Next, let’s talk about the Coverdell Education Savings Account, or ESA. These plans were very popular before the 529 plan was introduced, but are much less so these days. Like a 529 plan, a Coverdell ESA allows after-tax contributions that grow tax-free if used for education expenses. However, the Coverdell offers greater flexibility in investment options. You can choose from individual stocks, bonds, ETFs, mutual funds, and more, giving you more control over your investment strategy. Which, depending on who you are, may be either a good or a bad thing. Coverdell ESAs can be used for both college and K–12 expenses, including tuition, books, uniforms, and even certain tutoring costs. This can make them especially attractive for families who have private school expenses before college. A big downside for a Coverdell is that you can contribute only $2,000 per child per year, and there are income limits for making contributors.
In addition, the funds must be used before the beneficiary turns thirty, unless the account is transferred to another qualifying family member.
Next up, let’s talk about the often forgotten Prepaid Tuition Plans, or PPTs. PPTs are available in some states and allow you to pay for future tuition at today’s prices. If tuition inflation continues at its current pace, this can represent significant savings. You essentially purchase tuition credits, or units now, that can be used later, protecting you from future cost increases.
For example, if you purchase a prepaid plan when your child is in sixth grade at a cost of $10,000 per year, and by the time they attend college tuition has risen to $15,000 per year, you have saved $5,000 per year for each year of tuition. However, there are serious trade-offs to consider before jumping into a pre-paid tuition program. These plans are typically limited to in-state public colleges. If your child chooses to attend an out-of-state school or a private institution, the plan may pay only a portion of the tuition cost. And, obviously, it’s hard to know early on what college, or if any college, is in your child’s future.
In addition to these primary college savings tools, there are other more non-traditional ways to save for education:
You can use Roth IRAs: While primarily a retirement account, you can withdraw your contributions at any time from a Roth IRA without penalty, and you can withdraw earnings penalty-free if they are used for qualified education expenses.
However, doing so will reduce your retirement savings potential.
You can also use Taxable Investment Accounts: A regular brokerage account offers complete flexibility in investment choices and withdrawals. There are no contribution limits, but there are also no tax advantages specific to education.
Some people use a Family Matching Programs: With this strategy families choose to match a portion of what their teenager earns from a part-time job if it is saved for education. This approach both builds savings and reinforces the value of contributing to one’s own education.
Many families find that a combination of accounts and strategies works best.
For example, they might use a 529 plan for the bulk of long-term savings, a Coverdell ESA for K–12 expenses, and a small taxable investment account for flexibility.
When deciding on your strategy, it is helpful to weigh three key factors:
- Tax advantages: Which account type offers the greatest benefit for your tax situation?
- Flexibility: How important is it to have the option to use the funds for non-education purposes?
- Control: Who should ultimately decide how the funds are used, you, a family member or your child?”
As the school year begins, this is the perfect time to review your education savings strategy. Even small, consistent contributions can grow into a meaningful resource over time. By choosing the right mix of accounts and starting as soon as possible, you can reduce the burden of college costs and give your child a stronger start in their adult life. Think of your college savings like planting a tree — the best time was years ago, the second-best time is today, and you’ll be grateful for the shade when tuition season arrives.”
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