Written by Robert Powell
According to the College Board’s Trends in College Pricing 2023 report, tuition for an in-state student attending a public four-year school was $11,260, $270 higher than in 2022-23 (or 2.5% before adjusting for inflation).
The average cost of tuition and fees for the 2022–2023 academic year at public four-year colleges was $11,260 for in-state students and $29,150 for out-of-state students. For private nonprofit four-year colleges, the average cost was $41,540. That includes the cost of room and board (which, on average, according to the College Board, is around $12,990 annually) and other expenses like fees.
Assuming parents of a newborn start saving today to pay for their child to attend a four-year in-state school, they would need to save between $315 and $430 per month starting now, assuming college costs increase at 4% annually.
Alternatively, they would need to save between $730 and $850 per month if college costs increase at 8% annually. If that’s not enough sticker shock, consider the total future cost of four years of college starting in 18 years: $196,585 assuming a 4% annual increase, or $387,774 assuming an 8% increase.
To reach those goals, parents of newborns have several tools to save for and pay for college.
Section 529 Plans
According to the Internal Revenue Service (IRS), a Section 529 plan, which is a type of qualified tuition program (QTP), is a plan established and maintained by a state, or an agency or instrumentality of a state, that allows a contributor either to prepay a beneficiary's qualified higher education expenses at an eligible educational institution or to contribute to an account for paying those expenses. Read Topic no. 313, Qualified tuition programs (QTPs).
529 plans offer many benefits for education savings. For starters, earnings in the account grow tax-free over time. This means that, as long as the funds remain in the plan, you won't be subject to taxes on the gains.
What’s more, when distributions are made for qualified educational expenses — such as tuition for higher education or even for elementary and secondary public, private, or religious schools — the beneficiary typically doesn't have to report the earnings as taxable income.
However, if a distribution exceeds the qualified education expenses, a portion of the earnings may become taxable.
Another benefit is the ability to use 529 plans to repay student loans. You can withdraw funds to pay the principal or interest on the student loans of the designated beneficiary or their sibling.
However, there is a lifetime cap of $10,000 on the amount that can be used for loan repayments per individual. It's also important to note that interest paid using QTP funds doesn't qualify for the student loan interest deduction.
Prepaid Tuition Plans
Another type of QTP is a prepaid tuition plan. A prepaid tuition plan enables a family to pay for future tuition now in current dollars and prices, according to the IRS.
For instance, if a family invests in shares equivalent to half a year’s tuition at a state college, those shares will retain the value of half a year’s tuition — even 10 years later when tuition costs may have doubled.
The main benefit of these plans, according to FINRA, is that they allow a student’s parents to lock in tuition at current rates, offering peace of mind. The plans’ simplicity is also attractive, and most offer a better rate of return on investment than bank savings accounts and certificates of deposit. The plans also involve no risk to principal and are often guaranteed by the full faith and credit of the state. These plans might have an impact on eligibility for student financial aid, so make sure to ask your advisor about that or any other risks.
Read Section 529 Plans.
Coverdell ESA
A Coverdell Education Savings Account (Coverdell ESA) is a trust or custodial account set up in the U.S. solely for paying qualified education expenses for the designated beneficiary of the account, according to the IRS. This benefit applies not only to qualified higher education expenses but also to qualified elementary and secondary education expenses.
Contributions must be in cash, and you can't deduct them from your taxes. Anyone who earns below a certain income limit can contribute.
Contributions need to be made by the tax return deadline (without extensions). You can have multiple accounts for the same student, but the total contributions across all accounts can't exceed $2,000 per beneficiary in a year.
In general, the designated beneficiary of a Coverdell ESA can receive tax-free distributions to pay for qualified education expenses, according to the IRS.
Read Topic no. 310, Coverdell education savings accounts.
UGMA/UTMA Custodial Accounts
Custodial accounts under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA) are state-established legal structures designed to manage gifts or transfers made to a minor.
These accounts allow a designated custodian to control the assets until the child reaches the age of majority. During this time, the funds can be used for any purpose that benefits the child, such as covering educational expenses, including college or other needs that support their well-being.
Roth IRAs
A Roth IRA, though designed to be a retirement account, can also be used as a savings vehicle for college. You can use Roth earnings without penalty to cover qualified education expenses, such as tuition and fees. While there is no penalty, make sure to work with your advisor on if there are other stipulations that must be met, such as the account being open for at least 5 years.
It’s a good idea to be aware of the advantages and disadvantages of using a Roth IRA for college expenses and to consult a financial advisor. For instance, using Roth IRA funds for education can reduce retirement savings, has relatively low annual contribution limits that may not cover all education costs, may impact financial aid eligibility, and carries investment risks that could result in losses. Given all that, it’s prudent to consult a financial advisor who can help you assess whether it makes sense for you and your family.
Taxable Accounts
You can also save for college in taxable accounts and invest in a variety of investments and products, including stocks, ETFs, mutual funds, CDs, money market funds and savings accounts. Generally, with these accounts, you’ll be paying taxes on interest income, dividends and capital gains. Like always, all investing involves risk, so make sure to talk through that risk with your advisor.
Cash Value Life Insurance
You could also consider purchasing a whole life or universal life insurance policy to help cover college expenses. With a cash value life insurance policy, you can tap into the accumulated cash value to pay for college-related costs. However, it’s important to note that withdrawing from the cash value will reduce the death benefit of the policy.
Behind the 8-Ball
Some other resources to consider are federal student aid, such as federal grants, work-study funds and loans, to fund college costs.
Additionally, your children could apply to a two-year community college and then transfer to a four-year school afterward. Some students might also consider ROTC. Others might apply only to schools where they are in the top quartile of incoming freshmen based on GPA and standardized test scores, as these students tend to receive the most merit aid.
Now would be a good time too to meet with an advisor who is familiar with the federal student aid programs. Read Federal Student Aid.
Talk to an Advisor
As you can see, saving for and paying for college is no easy task. You may need to consider multiple strategies.
But choosing which strategy is best for you and your family will likely require consulting with a competent financial professional who can help you evaluate the advantages and disadvantages of the various options and select what’s best for your situation.
Read How to Save for College and Practical Steps to Saving for College.
