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Any parent or grandparent will tell you that their world revolves around the children. Our clients are no different. They want to give their children the best chance of success in life, and this includes their financial lives.
In today’s world, one of the best ways to do this is by funding a college education. Naturally, this leads to anxiety over the rising costs of college, and at Glassman Wealth Services we often get the question, “How much do I need to save for college, and what is the best way to calculate those costs?”
Step 1: Set a Realistic Budget to Build a College Fund:
One way to answer this question is to determine how much could be saved. This approach simply uses the extra cash in the bank or excess monthly cash flow as the starting point. While commonly used throughout the financial planning profession, this can result in mismatched expectations since the dollars could fall short of the ultimate goal, which may be to cover all college costs.
As an example, the average family saved only $453 per year and the total savings balance for college is just $2,331, according to Sallie Mae’s annual report, How America Saves for College. It’s obvious that this savings rate would not cover the cost of one year of tuition, let alone four years at a university. Consider that in just a decade, it is estimated that a public in-state college may be as much as $200,000, illustrating the wide disparity between savings rates and actual costs.
Step 2: Establish College Savings Goals
A better approach to answering this question is to start by clarifying the savings goal. First, we need identify the type of college education are we looking to fund. Are we funding a community college or Ivy League school? In our experience, folks tend to focus on funding the type of education that they had, looking to their alma mater as the baseline.
However, we’ve found that most people are not aware of the wide cost disparity between colleges. That is why we put together the chart below to illustrate the hypothetical cost of 4 years of college (tuition, room and board) for a child born in 2013:
Our favorite college calculators:
For those who want to narrow their focus even further, there are great resources that can help determine exactly what tuition rates are in a specific state or a particular school, and project the costs when the student enrolls in college. Some of the best 529 College Savings Plans (I explain what these are at the end of this article) have the most user-friendly calculators available. A few of our favorites include:
Step 3: Decide How Much to Save for College
Once the type of school has been identified, we can outline how much we need to save. A good rule of thumb is to use a 529 college savings plan to save 75% of the expected cost to avoid over-funding. The 25% coverage gap could come from current cash flow, scholarships, and loans to the student, or other means.
For example, let’s assume the goal is to fully fund a public in-state college for four years. According to the chart above, the total cost is $236,392 and we want to save 75% of that, or $177,294. Assuming an average 7% return over 18 years, parents should save $411.62 per month for 18 years, or $586.05 per month for 10 years (then stop). It pays to start early because those monthly savings jump to $624.19 and $774.79, respectively, if the child is four years old when savings start.
Step 4: Options for When You Can’t Save Enough for College
Sometimes the dollars are not available to save at this level and reaching the college saving goal may not be a reality. We believe it is better to know this years in advance and avoid the negative surprise after the acceptance letter arrives.
Many people consider reducing their retirement savings to redirect the dollars to college but this is rarely advisable. Just like an oxygen mask in an airplane, it is imperative that parents take care of themselves first. Not only would they model smart financial behavior, but also avoid a potentially dangerous situation. There are no loans or other funding options for retirement like there are for college costs. And most parents we talk to would rather their children shoulder the burden of student loans than have to ask to live with them because they cannot afford to live independently, the opposite of the boomerang scenario often seen with older children.
What is the best way to save for college?
After everyone recovers from the sticker shock of the potential cost of college and savings needed to fund the savings goal, the question becomes, “What is the best way to save for college?” 529 college savings plans are the preferred vehicle for saving for college because of the benefits they offer. They were created to incentivize college savings over time, and there is a wide array of plans available since most states and some private institutions sponsor their own. They all work similarly and have three key benefits:
- Contributions grow tax-free if used for qualified education expenses
- You may be able to write off contributions on your state tax return
- Dollars in a 529 plan are outside of the grantor’s estate, and you may continue to have control over whom the beneficiary is and how the dollars are invested
Knowing which type of plan is best for you and your future college student can be confusing, so I plan to review college savings plans in my next article: The Best 529 Plans: Review and Ratings.