In the 30 years from the 1989-1990 school year to the 2019-2020 school year, college tuition and fees tripled at public universities, according to CollegeBoard.org. And that’s after adjusting for inflation.
Public universities charged an average of $10,116 for the 2019-2020 school year for in-state students, per U.S. News & World Report. Out-of-state students paid more than double that on average, at $22,577.
Private colleges have more than doubled their tuition and fees during the past 30 years, again adjusting for inflation. In the 2019-2020 school year, private colleges charged an average of $36,801 per year. That’s more than the median personal income of $33,706 according to the Federal Reserve.
All of these figures reiterate what you already know: College has become absurdly expensive in the U.S. What’s less clear is how exactly middle-class families can shoulder these costs.
You have plenty of options at your disposal for saving and investing money, of course. But as you plan out a strategy for helping with your child’s college costs, observe the first rule of college tuition planning: Get creative and cobble together the funds from many different sources.
Ways to Save & Invest for College
Just as you want to combine multiple sources of funding for college costs, you should also combine multiple investing strategies for setting aside your own money.
Many middle-income parents jump straight to 529 plans and Coverdell Education Savings Accounts (ESAs) and ignore other options. These tools have their roles to play, but they also come with usage restrictions.
In a perfect world, you don’t pay a cent in net tuition costs because you and your child cover them through more creative options. In that case, the money you set aside in the investment vehicles below can go toward your retirement and your child’s inheritance, rather than contributing to administrative bloat at your child’s college.
No conversation about college savings vehicles would be complete without addressing 529 plans.
These tax-sheltered accounts work similarly to Roth IRAs (more on them below) but are designed for college costs rather than retirement. You pay federal income taxes on the contributions, but the money grows tax-free, and you don’t pay taxes on withdrawals when they are used for education expenses including tuition, fees, and textbooks.
Note: If you withdraw the money to use for other purposes, you pay penalties. Investor beware.
Some states allow you to deduct contributions from your taxable income. These rules vary by state and come with limitations.
Some states offer an alternative 529 plan model that does not operate as an investment account. The alternative model involves prepaying tuition in advance for in-state public universities, locking in a lower total cost.
Unfortunately, that also restricts your child’s choices. If they decide they’d rather matriculate to a school in another state, that means you — or they — typically pay the difference in tuition costs.
You can contribute up to $15,000 to a 529 plan in the 2020 tax year, tax-free. If your child gets a full-ride scholarship or otherwise doesn’t need the money for college, you can change the beneficiary. That could mean another child, a grandchild, niece or nephew, or even yourself if you want to go back to school.
Education Savings Accounts
Coverdell ESAs operate on the federal level rather than the state level. That makes the rules uniform nationwide, and you can also open the account through your regular brokerage account. This also means you can invest in whatever you like, rather than having to choose among whatever investments your state’s 529 plan allows.
For all those advantages, ESAs come with their own downsides. The contribution limits are lower at $2,000 per year, and the option to contribute phases out for higher earners starting at $95,000 for single filers and $190,000 for married filers.
The beneficiary must also use the money for education expenses before turning 30. Otherwise, you face penalties.
On the plus side, ESAs allow a broader definition of education-related expenses, including equipment like computers and services like Internet access.
Like 529 plans, be cautious about how much you invest in ESAs. As tempting as the tax benefits are, you don’t know what your child’s education needs will be when they’re young, and the restrictions on these accounts leave you with few options if you overinvest.
Roth IRAs, on the other hand, come with plenty of flexibility.
Although Roth IRAs are designed to be retirement accounts, you can withdraw your contributions at any time, for any reason, tax-free. And, of course, the contributions grow tax-free inside the Roth IRA account, with tax-free withdrawals helping you lower your taxes in retirement.
Sadly, Uncle Sam doesn’t let you contribute much each year. In tax year 2020, Americans under age 50 can contribute $6,000, plus an extra $1,000 for those age 50 and above for a total limit of $7,000.
I would urge anyone looking for a starting place for college savings to look to their Roth IRA first if they aren’t already maxing out their contributions. You still get the tax benefits of a 529 or ESA, without the tight restrictions.
Although it’s hard to get excited about bonds in the modern world’s perpetual low-interest environment, bond ladders can make for a low-risk way to contribute to your kids’ college education.
Bonds generally pay out regular interest payments on the principal price you paid when you bought them. When they reach their full term, they mature and pay you back the original purchase price.
In other words, you get a sudden infusion of cash at a predictable point in the future. You can time this to occur at a point when you’ll need it — like, say, when your child graduates high school and enrolls in college.
You can create a “bond ladder” by strategically buying bonds scheduled to mature at the exact intervals you’ll need them. For example, you buy one set of bonds scheduled to mature when your child first enters college, and another that matures in their second semester, and another in their third semester, and so on for all four years of their college career.
In between now and then, you get to enjoy the interest on those bonds as passive income. Just watch out for inflation, which can eat away at your bond’s face value. If you worry about inflation between now and your child’s college years, consider Treasury Inflation-Protected Securities as an option for your bond ladder.
And if your child covers their own college costs creatively, you don’t face any tax penalties on your bond ladder.
Along similar lines, you can buy rental properties while your children are young, enjoy the passive income throughout their childhood and teenage years, and then sell the properties as needed to help cover tuition costs. As time goes by, properties generally appreciate in value, even as your tenants pay down your mortgage for you.
You could also keep the rental properties and pump the rental income into helping out with tuition. Additionally, rental properties come with plenty of their own tax benefits.
Your rental properties can keep generating income for you as you enter retirement, helping you diversify your retirement income and reduce your exposure to sequence of returns risk. If you get sick of hassling with property managers, contractors, and tenants, you can sell the properties at your leisure.
Start a Business With Your Child
Your child should have at least some skin in the game, even if you also help out with college costs.
Consider putting your child to work if you own a business — or start a side business with them as a joint project. Pay out some of their earnings in immediate wages, and contribute the rest toward a college investment of some kind. Make sure to pay them something upfront or else they’ll lose sight of why they’re sacrificing their nights and weekends to work.
By starting a side hustle today with your child, you can teach them life skills, financial literacy, and of course to help you earn some money together. And it doesn’t hurt that you get some great parent-child bonding time working toward a common goal.
You could do something fun and hands-on like flipping houses, for example. That lets you teach them home renovation skills, how to manage and hire contractors, how to use leverage and loans for investing, how to estimate expenses and home values, and a dozen other skills.
Alternatively, you could start a virtual business with your teenage child. With their low startup costs, low overhead, easy technical outsourcing, and unlimited teaching potential — not to mention profit potential — explore an online joint business venture to help teach your child entrepreneurship. And it leaves you free to choose a niche that dovetails with your child’s interests, to keep their attention.
Get creative with it, incorporate your child as much as possible, and have fun together!
Whole Life Insurance
Permanent life insurance, like whole life insurance and universal life insurance, are plans in which there is an insurance component — the death benefit — and a cash component that can be partially withdrawn or borrowed against. As an added perk, the cash value in a permanent life policy does not count as a liquid asset when colleges determine financial aid eligibility.
When you borrow against your cash value, you don’t owe taxes on it, although you do have to pay interest on the loan. Borrowing against the investment component of the policy is a way to receive a portion of the investment — growth included — tax-free. On the other hand, if you make a withdrawal, you owe taxes on the earnings.
Because permanent life insurance policies are varied and fairly complex, review your options carefully. Don’t invest in permanent life insurance for the savings component unless you have a legitimate life insurance need.
Bear in mind that life insurance policies are not liquid investments. Most feature a surrender period during which you pay a penalty to access your funds. Make sure you fully understand the ramifications of borrowing or withdrawing from a life insurance account before tapping into it to pay for college.
If you will be at least 59 1/2 years old while your child is in college, fixed annuities could be an ideal way to save, at least so long as your annuity is out of the surrender period by the time you need to tap it.
A type of retirement investment, fixed annuities allow you to make withdrawals during retirement or receive a guaranteed income stream. Because money in a fixed annuity counts as retirement savings, colleges can’t consider it when determining how much financial aid you qualify for.
Beware that the IRS charges a stiff penalty for early withdrawals. Furthermore, the annuity company levies a surrender charge if you tap the annuity during the surrender period, which is usually the first five to seven years.
If you won’t be 59 1/2 by the time your child is in college, an annuity is likely a poor savings vehicle for anything other than your retirement.
When it comes to paying for college, the more sources of funding you plan for, the better.
Talk with your kids early on about what they should expect from mom and dad in terms of college help. Some parents never question whether to pay for their children’s college education, taking for granted that they’ll foot the entire bill. But your retirement savings must come before your kids’ college tuition. Helping to pay for their college education is optional. Paying for your living expenses in retirement is not. Don’t assume you can just work longer — in a troubling trend, forced retirements and layoffs of older workers have grown in recent years.
Furthermore, your children can borrow the money for their tuition if necessary, and at federally-subsidized interest rates. You can’t borrow money to cover your retirement expenses.
If you plan to help your kids with tuition, don’t be afraid to tie strings and conditions to that help. Require your kids to put some of their own time and money toward those costs, and get creative in covering college expenses through scholarships, grants, and other means.
Lastly, don’t hesitate to speak to a qualified financial planner to better understand the ramifications of your choices and find suitable investments. Pay particular attention to the tax implications, and stay as flexible as you can with your investments.
What other tips and ideas have you come across to save and pay for college? What do you plan on doing with your own children’s college costs?