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Saving for College: Understanding Your Options

Dear Carrie,

As a relatively new parent, I’m confused about the best way to save for my son’s college. He’s only 3 years old, but I want to get started now. What would you suggest?


Dear Reader,

First, let me say you’re smart to start thinking about saving while your son is still so young. As parents, we have a lot of financial obligations, and paying for college is one of the toughest of all. That’s especially true now with college costs rising at a rate much higher than inflation. In fact, the College Board estimates a child born this year will need more than $150,000 in today’s dollars to attend a four-year, in-state public university, assuming annual tuition increases of 3%; private schools will cost almost twice that (see “Up, up and away,” below).1 There’s just no getting around the fact that college is expensive.

Up, up and away

A child born today could to pay nearly twice as much for a four-year college education, be it public or private.

Cost of four-year, in state public college will increase from $85,788 to $152,753 in 18 years. Cost of four-year private college will increase from $168,896 to $300,734 in 18 years.

Source: The College Board. Estimates assume annual tuition increases of 3%.


So, clearly, starting early and contributing as much as possible are both important. But how you save is also important, for a number of reasons, including the impact on taxes and financial aid eligibility. Let’s take a look at the two most common college savings vehicles.

529 plans

I’m a big fan of these state-sponsored investment accounts, whose sole purpose is to save for college. These plans have four main benefits:

  1. Tax advantages: Although you contribute to the account with after-tax money, your investment grows tax-free and you don’t pay taxes (or penalties) on withdrawals so long as they’re used for qualified expenses such as books, room and board, and tuition. Many states offer residents a full or partial tax credit or deduction for contributions to their state’s plan—and some states allow you to deduct contributions to any plan.
  2. Improved financial-aid eligibility: A 529 is considered a parental asset. That’s important because only 5.64% of parental assets are factored in when calculating your Expected Family Contribution (EFC)—the number that determines your son’s eligibility for need-based federal student aid—while 20% of the child’s assets are considered.
  3. High contribution limits: 529 plans permit significant contributions, with many allowing $300,000 or more over an account’s lifetime. And you can contribute a tax-free lump sum of up to $70,000 ($140,000 per couple) by electing to treat the gift as though it were spread evenly over five tax years.2
  4. Flexibility: If your son receives a full scholarship or decides not to attend college, you can also change the beneficiary to another family member, such as a sibling, stepsibling or even yourself. On top of that, anyone at all can contribute, so a 529 presents a great opportunity for grandparents to support their grandchild’s future.

Custodial brokerage accounts

You could also put aside money for college using a custodial account. This is an investment account in your son’s name that you set up and manage on his behalf until he reaches adulthood. The advantage of this type of account is that it has fewer restrictions than a 529 plan. For example, you can make withdrawals at any time without penalty, so long as the money benefits the beneficiary, and there are no lifetime limits on contributions. The tax advantages, however, are few.

As with a 529, in 2017 you can contribute up to $14,000 ($28,000 per couple) to a custodial account without incurring the gift tax. But you’re only exempt from taxes on the first $1,050 of earnings per year. The next $1,050 to $2,100 is taxed at the child’s rate (often 10%—the lowest income tax bracket), and anything over $2,100 is taxed at the parents’ ordinary income tax rate.

More important, a custodial account is an irrevocable gift, which means the money becomes your child’s property once he reaches your state’s “age of majority” (usually 18 or 21). So, it’s a bit of a risk: Your son may spend the money on college, as intended, or he could choose something completely different!

Custodial accounts also put you at a disadvantage for financial aid. Because the accounts are considered a student asset, they’ll be factored into the EFC at the higher rate of 20%.

Don’t neglect retirement

Before saving anything for your child’s college, make sure you’re contributing the maximum amount allowable to your 401(k) or other retirement accounts.

I recently read that 20% of parents who had retirement funds were planning to use them to pay for their children’s college, while another 19% said they would do so if necessary.3 I think this approach is a mistake for two reasons. First, if you withdraw funds from a 401(k) or a traditional IRA before age 59½, you’ll pay taxes on the withdrawal, plus a 10% early withdrawal penalty. Worse, you might jeopardize your retirement.

As parents, it’s natural to want to put our children’s needs first. But you can use loans to pay for your child’s education if you have to. You can’t get a loan for retirement. So, as important as college is, our retirement should always come first. Think of it as another way of taking care of our children, by ensuring we’re financially independent once we’re no longer working.

In any case, I encourage you to carefully review all of your options, keeping in mind what’s best for you and your son. And congratulations again for thinking about this now. By starting to save for your son’s education early, you’re giving him a gift that will last a lifetime.

1College Cost Calculator.

2In 2017, an individual can gift up to $14,000 a year to an unlimited number of people, without reporting or tax requirements.

3How America Saves for College 2016, Sallie Mae.

What you can do next

  • Learn more about creating a customized financial plan and investment portfolio with Schwab Intelligent AdvisoryTM to work toward a better future for your family. Call 888-279-2756.
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