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A college education can be expensive. College Board research shows that tuition alone for an in-state student at a public four-year university can cost tens of thousands of dollars. It can be three to four times that for students at a private institution. Tuition has increased at a rate higher than the general level of inflation for decades.[i] That trend may continue. Proper planning can help reduce the financial challenge of sending your children to college.

The Impact of Early Investing

Beginning an investment program early can have a huge impact on its success. Even a small amount can go a long way. Just a few dollars a month could help your child meet expenses many years from now that are considerably larger than they are today. That’s why it is important to start early.

It is easy to put off monumental tasks. But starting a small college investment program early can set your children up for financial success. The impact early investing has on a child’s future college education costs is huge for three reasons.

The first is that the earlier you start contributing, the longer you can contribute. Second, the more time you have to save, the more you can accumulate. And finally, the more you accumulate, the greater the impact of the time value of money.

The Effect of Compounding Interest

Time is an investor’s ally. Each year, whatever amount you set aside for your child’s education will earn a return. In the first year, that return is added to the principal you invested. The second year’s returns are earned on this balance, plus new contributions. This process continues until your child is ready to start college.

This cycle of continual contributions and earnings on accumulated balances, has a multiplying affect known as compounding. The accumulated balances grow because you are adding to them. The sum of this money grows by an additional amount based on the return it earns. The longer you leave the money invested, the greater the compounding affect.

Opportunities to Save for College

There are specific ways you can save for education expenses. Some of which offer tax benefits over a traditional bank or brokerage account. These include:

  • Coverdell Education Savings Accounts
  • 529 Plan College Savings Pans
  • Prepaid College Tuition Plans
  • Uniform Gift to Minors Act Accounts 
  • Uniform Transfer to Minors Act Accounts

The Coverdell Education Savings Accounts

Coverdell Education Savings Accounts, or ESAs, used to be called education IRAs. They allow anyone (subject to certain income limitations) to invest up to $2,000 per year per beneficiary under age 18.

ESA contributions are not tax deductible, but investments in the account grow tax free as long as the money is used for qualified elementary, secondary, or college education expenses. Withdrawals not used for qualified expenses are subject to income tax on the earnings, plus a 10 percent penalty.

529 College Savings Plans

One of the most popular college savings options is the 529 college savings plan. Investment earnings in a 529 plan also grow tax free, as long as the money is for qualified education expenses. 529 savings plans have much higher contribution limits than ESAs.

Like an ESA, funds in a 529 Plan must be used for qualified education expenses. If you use the money any other way, then withdrawals will be subject to ordinary income tax on the earnings and a 10 percent penalty.

Each state administers its own 529 plan and can set a maximum balance you can accumulate in it. You can invest in any state’s plan, even if you don’t live there or plan to have your kids attend college there.

Different plans may be run by a different investment managers, offering different investment options, and charging different fees. Many states offer residents an income tax deduction in the year they contribute.

If your child ultimately decides to not attend college, you can change the beneficiary or the owner of a 529 plan without tax consequences.

Prepaid College Tuition Plans

Another option offered by 529 plans is a Prepaid College Tuition Plan. These plans allow you to prepay future tuition costs at current rates. There are potential drawbacks on prepaid plans.

The first is that you may have to be a state resident to use these plans. The second is that the maximum value is usually only possible by attending public in-state colleges. You can’t use the credit anywhere else. This relates to the third drawback.

Buying prepaid tuition caps your theoretical investment return. The funds can only grow at the rate of that state’s tuition costs. Investing your 529 funds outside the prepaid plan may offer more options and the potential opportunity for better returns.

Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) Accounts

UGMA and UTMA accounts are a way to transfer assets to minors without setting up a trust. These accounts aren’t specifically designed to help pay for college expenses. However, many parents and grandparents use them for this purpose.

These custodial accounts are very easy to open and can invest in a variety of securities and funds. They don’t have contribution limits or special tax advantages, other than earnings and realized gains are taxed at the child’s (presumably) lower marginal rate.

Having a UGMA or UTMA can affect your child’s (or grandchild’s) ability to qualify for financial aid. What’s more, the assets in these accounts become the child’s property when he or she reaches the age of majority (18 or 21, depending on the state). The money is unrestricted and doesn’t have to be spent on college expenses.

Your College Investment Plan can be Fluid

There are a number of programs and strategies to help you save for your children’s college education. Each with unique benefits and drawbacks. So, it’s important to understand that choices made when your children are young can be changed as time goes on. Your savings plan can be flexible and fluid.

The important step is to start investing as soon as possible. Invest regularly in way that makes sense for your family. Then, make changes to your plan as necessary along the way.

For help setting up your plan, use our College Savings Calculator or contact a Member Service Representative to help walk you through the process.

[i] Source: College Board, Trends in Higher Education Series, Trends in College Pricing 2019, November 2019

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