How to Start a College Fund for Your Child

Anyone with young children knows that kids are both a blessing — and a cost. From diapers to day care and tater tots to toys, the day-to-day expenses of a growing family can add up fast.

According to the USDA Opens in new window, middle-class parents are looking at nearly a quarter million dollars to raise a newborn. But when you add in the potential cost of college, you could be seeing double. And although the day your little ones first step onto campus may feel like a lifetime away (especially during those early sleep-deprived years), starting to save now may be the best thing you can do — for yourself and your kids.

Higher-priced education

If you haven’t shopped colleges lately, prepare for sticker shock. For the 2019–20 school year, the cost of attending Opens in new window a private college averaged $53,980. For public schools, typical in-state students could face a $26,590 bill. And if a student went public but came from out of state, add around $15,000 to that price tag.

The good news: Those are “rack” rates. Everything from scholarships to loans to housing choices can cut the actual “net” price you pay by $10,000 a year or more. The bad news: Those are the current costs — and both the sticker and net prices are headed in only one direction.

Saving is never easy. Saving for college may seem like gargantuan goal. But remember the proverb: “How do you eat an elephant? One bite at a time.” Putting away even small amounts now can help make a sizable dent in your child’s college bills later. Here are three ways to approach it.

Invest through a 529 plan

Named for a section of the IRS Code, state- (and sometimes institution-) run 529 savings plans hold unique advantages. First, you get a wide array of investment options. Next, the money you invest grows tax deferred — and withdrawals are federal tax free if you use them for “qualified education expenses Opens in new window.” (Many states offer their residents tax breaks on 529s too.) Thanks to the power of compound interest, that could be a big advantage if you start investing early.

But if the thought of investing scares you as much as a toddler having a temper tantrum in a crowded restaurant, fear not! Many 529 plans offer an age-based option: You specify the year you expect your child to start college, and your money goes into a diversified “target-date” fund whose investments automatically grow more conservative as that year approaches.

What if your kid’s plans for college change? 529s also let you switch the account to a different beneficiary (a sibling or even a spouse). The tax law has also become more flexible through recent legislation so that the funds can be used for K-12 education or to repay student loans (each with limitations on amounts). (Worst case: You can withdraw for any reason and owe income tax on your earnings, plus a 10% penalty — or 12.5% if you live in California.)

Bonus: You won’t know exactly how much college will cost until you get there. If you end up with more money in a 529 than you’d needed, thanks to the new federal SECURE Act you can use the funds to help your child pay off student loans.

To help your 529 account grow, ask grandparents and other relatives to consider 529 contributions in lieu of gifts. They can open an account in their own name or contribute directly to the plan you’ve already established.

Consider a custodial account

You don’t need to know what UGMA and UTMA stand for to know they can help fund college. (For the record, they’re Uniform Gifts to Minors Act and Uniform Transfers to Minors Act accounts, respectively; which applies to you depends on which state you live in.) But forget the acronyms. Simply put, a custodial account is an investment account you open on behalf of a child. There’s no limit on deposits, other family members can contribute, and you (or the designated custodian) can withdraw anytime without penalty — though keep in mind that the money is meant to be for the child’s benefit. Also, account earnings are generally taxed at the child’s typically lower rate.

Downsides: Because they’re owned by the child, UGMA/UTMA account assets weigh more heavily against them when applying for financial aid for college. (Parents’ assets count less on the federal FAFSA^® application.) Unlike a 529, you can’t switch beneficiaries once you’ve set up an account in a child’s name. And once the child comes of age (18–21, depending on your state), they become the custodian and control where the money goes — which might or might not include, uh, college.

Open a Roth IRA

IRA stands for individual retirement account. But did you know that the Roth version of IRAs can also help you save for college?

Unlike a traditional, tax-deductible IRA, with a Roth you invest after-tax dollars — and can withdraw your money federal tax free if you hold the account at least five tax years and meet other criteria. And if you use the proceeds to pay for education, you won’t face an early-withdrawal penalty if you’re under age 59½.

Unlike 529s and custodial accounts, Roth IRAs have strict contribution limits, which tend to rise every couple years. For 2020 it’s $6,000 ($7,000 if you’re age 50+), but it could fall to zero depending on your income. (You may be able to get around that through a “back door” conversion; ask your tax advisor for details.) If you and your spouse each invest $6,000 a year for 18 years, assuming 6% annual earnings you could have more than $400,000 to split between college and your retirement nest egg.¹

Of course, that assumes you’re saving for only one child’s college education. And that brings up a critical consideration: In general, it’s best to put your own financial future before your kids’. After all, retirement is the one major expense you can’t borrow to cover.

Even so, (especially) if you’re already saving for retirement through a workplace plan or traditional IRA, a Roth IRA can be a great addition to your college funding toolbox.

Footnotes

¹ The compounding concept is hypothetical, for illustration only and not intended to represent the performance of any specific investment, which may fluctuate. You can lose money by investing in securities.

Ira Hellman is a senior writer at Prudential.

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