Personal Finance Essentials
Saving for College
Where You Save Matters as Much as How Much You Save and
One of the Most Common Instincts Parents Have is Exactly Wrong
Start as Early as Possible
The most powerful tool in college savings is time. Even a small amount saved consistently from the day a child is born has years to grow. To accumulate enough to send a six-year-old to college, a family needs to save anywhere from $770 to $1,550 per month, depending on the rate of return and type of school. Most parents are not saving at that rate – or anything close. And every year of delay increases the gap that must be closed in a shorter time.
The lesson of compound interest is simple but consistently underestimated: time in the market is more valuable than the amount invested. A family that begins saving when a child is born has a fundamentally different set of options than one that starts saving when the child is 12.
Do Not Save Money in Your Child’s Name
Many parents instinctively save for college in an account under their child’s name, using a UGMA (Uniform Gifts to Minors Act) or UTMA (Uniform Transfers to Minors Act) account.
This is a mistake, for three reasons:
First, the tax advantage has largely disappeared.
Second, the child legally owns the money.
Third, money held in a child’s name is assessed more heavily in financial aid calculations than money held in the parent’s name.
What to Do If You Already Have a UGMA or UTMA Account
If you have already established a UGMA or UTMA for your child, you cannot undo it – the gift is irrevocable. However, money in these accounts can legally be spent for the benefit and welfare of the child, which covers far more than just college: school supplies, tutoring, music lessons, sports programs and other legitimate expenses all qualify. By gradually using the UGMA funds for ongoing child-related expenses – while simultaneously building a new account in your own name – you can reduce the UGMA balance over time and move assets into a more favorable structure before the child turns 18. Keep good records and receipts for all withdrawals.
The Education IRA and Its Limitations
The Coverdell Education Savings Account (originally called the Education IRA) allows contributions of up to $2,500 per child per year for families with qualifying income, with withdrawals used for educational expenses being tax-free. The concept is sound. But the contribution limits are low, the income restrictions are significant, and – critically – using a Coverdell ESA can disqualify you from claiming certain education tax credits in the same year. In most situations, a 529 College Savings Plan provides substantially better benefits and flexibility.
Never Sacrifice Retirement Savings for College
This is one of the most important principles in personal finance, and one of the least popular: your retirement savings take priority over your children’s college savings. Always. Your children can borrow for college. They can take student loans, choose a more affordable school, work during school, or receive employer tuition assistance. You cannot borrow for retirement. There are no retirement loans. If you arrive at retirement without sufficient savings, your options are extremely limited and none of them are good.
Withdrawing from IRAs, stopping 401(k) contributions or liquidating retirement accounts to pay for college creates a gap that is almost impossible to recover from – not only because of the lost principal but because of all the future compounding that money would have generated. Do not raid your retirement savings to pay for college. Their education is important. So is your financial security.
