Let’s do the numbers: the average cost of sending a child to 4 years of private undergraduate school, including room and board, is $163,668. If you want to shoot for the big leagues – those of the Ivy persuasion – you are looking at $225,628 for 4 years at a school like Harvard. How about a college with a division 1 football program like the University of Michigan? $208,608. And remember that whole concept of your state school being your fall back school? For New Jersey residents who want to attend Rutgers and live on campus, the cost is $25,077 a year, a little more palatable, but you’re still staring down the barrel of $100,000 for 4 years.
It’s the eight-hundred pound gorilla in every family. It looms over all parents like the grim reaper. We joke about it at BBQs and parties, chuckling about the insanity of it all, before going back to our beers and margaritas. But deep down, the question fills us with dread: How the hell are we going to pay for college?
Here are 7 options and factors to consider when trying to answer that scary question.
1. The 529K
The bellwether of college savings. You almost feel like a bad parent if you don’t open one of these. But are they really that great? For the uninitiated, a 529k is a state-run fund wherein you contribute tax-free money, and then you can withdraw the money + earnings tax free as long as you use it for higher education. Overall, it’s a pretty great deal. So what’s the downside? Well, for starters, you can’t pick your own stocks. Like a mutual fund, your money is being managed by a stranger, and like a mutual fund, many 529s underperform the S&P 500. Plus, there are management fees, just like a mutual fund. So it’s a toss up.
If you’re a passive investor who wants to sit back and not have to make choices about your assets, then the 529 may be for you. But if you’d rather buy $5,000 worth of Apple stock each year, you can’t do that in a 529. You’re at the mercy of the state program.
Finally, look out if you need that money for something other than college. You’re going to get walloped with income taxes, capital gains, PLUS a 10% withdrawal penalty.
Every state has their own 529, and some are more respected than others. Start by looking into your own state’s plan, because it may offer a state tax deduction. If not, consider some other states like Ohio and Nevada, which are consistently ranked highly. And if you really want to get deep into your research, check out this article from Forbes where the author creates a pretty decent formula for choosing the right 529.
For me, I once put $10,000 into a 529k and 3 years later it was worth…. well, the same $10,000. Zero growth. All the while I watched my personal stock accounts accumulate nice returns. Eventually, I cashed out the 529 plan and looked elsewhere for college savings.
2.The Roth IRA
Ah, the Roth. The greatest gift Uncle Sam has bestowed upon his citizens. If you don’t have a Roth already, stop reading and go open one (assuming you are under the income limits of $181,000 combined for a married couple filing jointly. If you make more than that, you can look into a backdoor Roth IRA, but please speak to a financial advisor before doing so). The flexibility of the Roth IRA is simply astounding. If you put $5,000 into a Roth today, and it grows to $505,000 by the time you are 65 (retirement age), you can pull out all $500,000 of earnings without paying a dime of taxes. Okay, great for retirement, but what does that have to do with saving for college? Well, in a Roth, here’s the beauty – whatever contributions you put in, after 5 years, you can always take out, tax free. Again – whatever original money you put into a Roth, you can take out without penalty to use for whatever you want – a car, a vacation, a massage chair – as long as it’s been in the account over 5 years. As for the earnings? If you take profits out before 65, you are typically charged taxes and penalties. But if you take profits out to pay for higher education, you avoid the 10% penalty. The government gives you a free pass on that one (you still have to pay the tax). Think of all that flexibility. You can fund your retirement account, and 18 years later, when it’s time for your kids to go to college, you remove the original funds, for free, and you still have the earnings in the Roth creating a nice nest egg for retirement.
The big negatives about the Roth are the income limits and $5500 max contribution per parent, whereas the limits on the 529k are usually huge, upwards of $300,000 lifetime total. But even if you squirreled $5,500 into a Roth for 18 years, you’d still have saved $99,000 for college, and funded your own retirement with it at the same time.
3. The Coverdell/ESA
The 529 and the Roth have a little baby brother hanging around out there, and nobody seems to know about it. It’s called the Coverdell, but it also goes by the initials ESA – Education Savings Account. It ain’t much, but this bad boy let’s you tuck away $2,000 per year by opening an account in your child’s name and then gifting them the money each year to fund it. And it works just like a regular Roth, but for college. The $2,000 you put in each year, plus all the earnings (this is where it’s even better than a Roth) are not taxed and are not penalized if they are used for education. And not just for college – any education, including primary and secondary school. So if you start an ESA when your child is born, you get the $2,000 a year times 18 years = $36,000, untaxed. Plus you get all the earnings on that, which, at a modest 6% return, would be a total of over $71,000 if you fed the account every year – again, all of it untaxed and unpenalized. Between the Roth and the Coverdell, you’re looking at potential $144,000 of base contributions + $35,000 in earnings from Coverdell. That takes you to $179,000. If you and your spouse each do this for each kid, you would come very close to covering your college costs in a two child home.
4. Financial aid
Over two thirds of college bound students receive some kind of financial aid. But remember, when you apply for it, the universities look at assets being held in your child’s name. Here’s what the fantastic website savingforcollege.com has to say abut it:
“Each school will set its own rules when handing out its own need-based scholarships, and many schools are starting to adjust awards when they discover 529 accounts in the family. If you think you’re going to need financial aid, look carefully into how both the Roth and the 529 affect your chances.”
Visit their website for a more in depth look at how your college savings plans could affect your child’s financial aid.
5. Will Your Child Even Go To College?
It has to be asked, especially in this rapidly changing world – are you sure your child will go t0 college? If he or she doesn’t, you’re going to be in trouble with the 529k, because not only do you pay taxes on the gains if you take it out for something other than college- you get a penalty of 10% to boot! Ouch. Your money is trapped, unless you take the hit. The funds can’t be withdrawn tax/penalty free for anything else. The best you could do is transfer the account to another family member who is college-bound. On the other hand, if you have your money in the Roth IRA and your child skips college, no problem… that’s just more in the nest egg for you and your spouse to enjoy in retirement. When it comes to flexibility, the Roth is clearly the victor.
6. The Skim
Those 529 plans you plunk your money into are being “managed” by would-be gurus who are guiding your dollars towards greener pastures. And the cost for them often underperforming the actual S&P year after year? They skim a percentage off the top, somewhere between .7% to 1.2%, which over 18 years will costs you a few thousand dollars. May not seem like much, but that’s about the cost of one year of books and supplies at most colleges. Make sure to factor the management fees into the equation when choosing a 529 that’s best for you.
7. Build Equity In Your House… Then Sell
Sounds dramatic, but it’s a legitimate maneuver that can have big benefits all around. The catch, of course, is that you have to be willing to downsize when junior goes off to college, and that can be tricky, especially if you have other kids in grade school, of if you are so attached to your house that you think of it as your “forever home”. But if you’ve always dreamed of “moving back into the city”, this could be a great option. You pay down your loan and build up your equity, and when your child turns 18 you sell the house and downsize into something about $100,000-$200,000 less. Pocket the cash and use it to pay for college.
One of the great bonuses of this option is that you can justify upgrading to a brand new kitchen or spa-like master bathroom. Enjoy the new features and sleep soundly knowing you put money into “the bricks”.
Another real estate market collapse notwithstanding, your additions should fetch you significantly more money on the open market when it comes time to sell. Even if you do have more kids coming up through the school system, you could still downsize without changing districts.
The costs of college tuition are staggering, but luckily there are a few options out there that can ease the burden for you and your family. Consider a 529k in a state with a low-fee, well-run plan, but be aware of the restraints on using the money for anything else and the lack of control you have over your investment. The Roth IRA is obviously favored in this article, for its staggering amount of flexibility and for being able to withdraw the original contributions for any reason, any time, tax and penalty free (again, if you are over the income limits, look into a backdoor Roth). The Coverdell account would be the best of both worlds, except for the fact that you can only invest a paltry $2,000 a year. Still, don’t ignore it. You get the contributions and the earnings tax and penalty-free if you use the money for college. The trick there is to start early so that you can build up some of those tax-free earnings over a full 18 years. Finally, you can invest in your own home if you’re willing to downsize, or if all of this seems too much, you can simply open a standard taxable stock account and buy a stock that should be around ’till the day you die, like Coca Cola. You don’t get any tax breaks, but you have complete control and access to the funds at all times.
It can all be a bit overwhelming. But what you shouldn’t do is bury your head in the sand… because when it comes to the battle against the outrageous costs of college tuition, every dollar counts.