With the costs of higher education constantly rising, it is more important than ever that parents start saving as early as possible.
So, when is the right time to start?
Ok, but how do we start?
Contrary to what you may think there are lots of ways to start accumulating college savings on a tax-advantaged basis at any time you’d like for your family, regardless of whether your child is even born.
I’ll introduce two of the college savings strategies that I’ve started for my daughter, Julia, who isn’t due until late March 2021. As a future parent-to-be and fully intent on saving for college sooner rather than later, I felt like it would only be appropriate to share these tips so others may benefit.
Note: These financial vehicles are just a couple of tools and only scrape the surface when it comes to a broader college funding strategy within a comprehensive financial plan. If you want to learn more beyond this blog post or just don’t know where to start on your college funding journey, I encourage you to attend our free educational webinar: Little-Known Secrets of Paying for College.
Vehicle #1: Open a 529 Savings Plan
The first option is to open up a 529 college savings plan, preferably in your home state if you pay state income taxes.
State Tax Deductions
Some states, like Pennsylvania or Arizona, will allow you to deduct contributions to an out-of-state 529 plan for state income taxes. Of course, if you live in a state like Florida or Texas with no state income tax, it doesn’t matter which state’s plan you contribute to. And then there are those states that do have income tax but do NOT offer tax deductions for 529 contributions (e.g. California, New Jersey).
To figure out what your state does, check out your state 529 website or explore this in-depth savingforcollege.com article.
My wife Debora and I live in Virginia, so we have chosen to open a Virginia 529 account. I am the owner and the beneficiary of the 529 account (for now). We did it that way to simplify the account opening process, but you could open a 529 for the benefit of your spouse or another family member if you’d prefer.
If you do it this way, plan to change the beneficiary on your 529 to your child once he or she has a social security number. Typically, it takes about a month after your child is born before they’ll receive a social security number.
The Power of Tax-Advantaged Savings
As Virginia residents, we can deduct up to $4,000 per account per year on our state income tax return, and so it’s not a bad idea to try to contribute $4,000 per year to a Virginia 529 account. My goal this year is to contribute this maximum deductible amount of $4,000 to my child’s 529 account (or $333.33 per month) and to continue doing so until Julia graduates from college in the year 2043.
If I stick to that strategy, the total tax savings I would receive from my home state of Virginia would be $4,000 x 22 years x 5.75% (the Virginia flat tax rate) = $5,060. My net after-tax investment for Julia’s college savings account would thus be $82,940.
Let’s assume that I never take a distribution from Julia’s 529 account until she’s 22. We’ll also assume that I realize an average annual rate of return of 7% inside the 529 (i.e. the investment return net of fees and expenses).
In 2043 the account value inside my 529 would have reached an estimated $196,023 in total. That is almost 2.5 times my net investment of $82,940.
For some families, you’ll be able to contribute and save much less or much more, but in general, saving in a 529 account that is invested for the long term is a good move.
Note: Some families worry about 529’s negatively affecting their student’s chances of qualifying for need-based aid. Here are two blog posts that delve into this further:
- Read: College Financial Aid – Know the Rules!
- Read: Paying for College for Divorced Families: A Closer Look at Financial Aid Strategies
Vehicle #2: Whole Life Insurance
The second account that I’ve opened for Julia’s college savings is whole life insurance that will be paid up on a guaranteed basis by the time she is twenty years old (called a “20-pay”).
Many people have a negative view of life insurance and believe it to be an expense rather than an asset. That is true with term insurance, but whole life is both insurance and investment at the same time.
For example, I am the owner and the insured, and my monthly premium is approximately $110 per month. When Julia is in college, the policy will have over $30,000 in cash value that I can take from the policy on a tax-advantaged basis.
The Surprising Flexibility of Whole Life
Those funds will never be subjected to market risk and will serve as the conservative allocation in her college savings portfolio.
Assuming I spend most of the cash value for her college expenses, there should still be about $40,000 in net death benefit left in the policy after it’s paid up in 20 years.
If I were to pass away at any point during her childhood, my wife Debora is also guaranteed to receive at least $50,000 in tax-free proceeds that would help pay for Julia’s college education.
Lastly, I can transfer my whole life policy to Julia after she turns 18 by using the “transfer of insured” rider which comes with my policy at no additional cost. By transferring the ownership of the policy to Julia as well, she would then have a little permanent life insurance for her family one day.
Alternatively, I could also keep the policy on my life and “earmark” the residual death benefit as part of my legacy that I’ll hopefully leave behind for Julia’s children’s college education (i.e. for my grandchildren).
What If Your Child Doesn’t Go to College?
You may be thinking to yourself, “life rarely works out like this…what if my child never goes to college?”
That thought has crossed my mind many times. The worst-case scenario with a 529 is that you may have to change the beneficiary to another family member or you’ll have to pay a 10% penalty and taxes on the growth inside of the account if the funds are dispersed for anything other than qualified education expenses. This is one reason why some parents actually opt for a Roth IRA or use one in tandem with a 529.
Here’s something that many people don’t know: You may be able to use your 529 to fund an alternative educational path. We’re talking about mountain adventures, survival school, international gap years, and more.
Thankfully, there is no requirement to use cash value from whole life insurance for education, and thus I can use that cash to help pay for Julia’s car, house, or wedding. Either way, I’m sure Debora and I won’t have a difficult time finding a good reason to spend those savings!
I realize that parents already have many expenses to cover, from getting food on the table to doctor’s bills to buying that new house, so saving for college right now could be low on the priority list. That being said, time is your greatest resource and before you know it you’ll be trying to pay for college while also trying to save as much as you can for your retirement.
I feel strongly that the more you can do today to budget even just $100 per month to start saving for college, it will pay dividends for you and your family in the long term.
Thanks for reading! I hope it was helpful as you plan wisely for the future. Feel welcome to reach out to me or one of our College Funding Coaches should you have any questions.
Everyone is busy. Being busy is essentially an American pastime at this point. At The College Funding Coach, we recognize that many of you could figure all this out on your own, but you just don’t have the time or energy to do so. If you have more questions and have already joined us for an educational webinar, don’t hesitate to reach out and schedule a FREE consultation with one of our college funding experts.
Jimmy Hicks, CFP®, ChFC®, ChSNC™, CFBS, CLU®, MBA
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