As parents, we want what’s best for our children.  Quality education is a big part of that.  However, many of us are worried about not being able to save enough money for our kids’ college, and rightfully so.

The estimated cost of putting a baby born in 2020 through a 4-year public out-of-state college 19 years from now is $352,396 or almost equivalent to buying a median-priced home in New York today for all cash ($328,677).

Saving that much money, especially if you are like me and have more than one child, is an overwhelming task.  Moreover, there is a lot of confusion and misconceptions about the 529 education savings plans.  So, even if parents have the right intentions, they might end up waiting too long before opening a qualified tuition plan or doing nothing at all.

The sooner you get started on the right path, the less money you will need to save!  According to some estimates, if you open a 529 plan soon after your child is born, approximately one-third of the amount needed for college will come from the compound interest growth!  If you wait until he is in high school, less than 10% will come from earnings.

Are you ready to learn the basics of 529 plans and start saving for your kids’ college?  Let’s break it down.

What’s a 529 plan?

A 529 education savings plan is a tax-advantaged investment account that can be used to save for education-related expenses for a designated beneficiary (aka your lovely kiddo).

These plans are run by states. You don’t have to participate in the plan offered by the state you live in, and your child is not restricted to go to college in whatever state you choose for a plan.

The after-tax money you put in a 529 grows tax-free. Withdrawals are also free of income and capital gains taxes if they’re used for qualified education expenses. This includes the cost of college itself (tuition, room and board, books, computers, etc.), plus you might get state tax benefits on contributions, depending on the state you live.  You might have to choose a plan from your state if you wish to claim the benefits.

529 plans can also be used to cover private k-12 tuition of up to $10,000 a year, but this post will focus on college education.

For example, you invest $20,000 in a 529 plan, and over 18 years that investment grows to $50,000.  You will not have to pay taxes when you withdraw that money and spend it on education.

If you put $20,000 in a regular investment account, you would be paying long-term capital gains taxes of up to 20% on $30,000 that your investment made (aka $6,000 out of your pocket).

Setting up a 529 plan

Parents usually set up a 529 account in their own names, with their child as a beneficiary.  This set up has the least impact on financial aid eligibility.

Also, since you’re the account owner, you (not your teenage child who might want to splurge on a nice ride or European vacation) have control of when and how your money is spent, even after the person you’re saving for becomes an adult.

If your kiddo has well-meaning grandparents who are happy to pitch in for his higher education, there is one thing you should keep in mind.  If they set up a 529 account in their names, withdrawals from that account will be counted as untaxed income to the student on the financial aid forms.  That could reduce need-based financial aid eligibility by as much as 50% of the amount withdrawn.

Setting up a 529 plan is easy.  Visit Vanguard or Fidelity, two of my favorite brokerages, to get started.

Investment choices

A 529 is an investment account, which means that the money you deposit will be invested according to the option you choose.

To make things simple, 529 plans typically offer ready-made age-based portfolios.  This means that your money will be invested in the mix of stocks and bonds (or stock index funds and bond index funds) that will be adjusted with your child’s age.

When your kiddo is young, the investment mix will be riskier and have more stock funds in it.  As your child gets older and approaches college years, your mix will shift towards more conservative options (aka bond funds).

You should pick the option that is closest to your child’s age and that most closely matches your tolerance for risk (conservative, moderate, and aggressive).  It’s important to choose an investment mix that you are comfortable with.  The one that won’t keep you up at night when the market is volatile, but it should also have the potential for growth so you can reach your saving goals.

Most 529 plans allow you to set up automatic monthly contributions.  Take advantage of this option.  Determine how much you are going to contribute monthly, set up automatic transfers, and forget about it.

One last thing to keep in mind when choosing investment options for your 529 plan is fees.  Each plan is different, so make sure you know how much you’ll be paying in asset-based expense ratio, annual maintenance fees (aim for $0), and enrollment fees (same, should be free).

Fidelity has a great tool to help you make a selection – 529 college savings plan comparison.  Use it to find the right plan for you and go over all the details, including investment options offered and fees paid by the account owner.

A million-dollar question – how much money to contribute

This is a very personal decision based on your current financial situation, your personal preferences, and how much you love your child (kidding on the last one).

Do you currently have credit card debt, no money in your emergency fund, or zilch in your retirement savings?  If the answer is yes, then don’t even think about saving for your kids’ college.  Improve your own financial situation first. 

What are your expectations of your child?  You may want to save 100% of college expenses or maybe less if you feel like he should also be able to contribute in some way.

A lot of financial advisors would recommend the “one-third” approach to save for college:

• Save one-third of the costs with a 529 plan
• Pay one-third of the costs out of your current income while your child is attending college
• Finance the remaining one-third with loans.

Can you reasonably estimate how much college is going to cost in the future?  Higher education costs are rising every year, so it makes it difficult to know how much money you’ll need.  There are many college cost calculators out there to help you figure out how much money you should be saving.  The one I like is created by the College Board.

For example, using that calculator I can estimate that if I’m paying for 100% of college expenses, I will need to save $593,588 for both Nathan’s and Milan’s education at a 4-year private college.  Wow!

Is there a maximum amount I can contribute?

Yes and no.  IRS considers the money that you contribute to a 529 plan a gift to your child.  Each person can gift up to $15,000 a year without having to pay a gift tax.  If both my husband and I are contributing to our children’s 529s, we can invest up to $30,000 a year without having to pay a gift tax.

You could always contribute more as long as you’re willing to pay gift taxes.  A side note – each child should have his own separate 529 plan.

If you have a lot of extra cash laying around and you’re eager to kickstart college savings, you could “super-fund” a 529 plan.  You can make 5 years of contributions at once, or $75,000 (up to $150,000 for married couples), but then you can’t contribute again for another 5 years.

What happens if my child doesn’t use it?

Your child might get a scholarship (Yay!), decide not to go to college at all, or higher education will one day become universally free (haha…wishful thinking).  What happens to your money then?

You have a couple of options.

First, you can transfer the money to another child or even yourself if you decide that you want to go back to graduate school.

Second, you can withdraw the money, but you will have to pay taxes on the investment earnings plus an additional penalty fee of 10%.

529 plans and financial aid

529 plans generally don’t have a very big effect on financial aid eligibility.  When the federal government determines your eligibility, parents’ or students’ income matters far more than savings.

Only up to 5.64% of the value of a parent-owned 529 plan will count toward the family’s expected contribution.  Decades of tax-preferential compounding growth far outweigh this potential downfall, in my view.

Balancing saving for retirement and college

Balancing saving for your own retirement with saving for your kids’ college education is a very personal decision.

I think you should secure your own financial future first, then worry about your children’s education.  You don’t want to be a burden to your kids during your golden years.  Always remember – there are grants, scholarships, and loans for college, but there are no loans for retirement.

The bigger picture

There you have it – the ins and outs of saving for your child’s college with 529 plans.  This post covers a lot of ground, but I don’t want you to feel overwhelmed with all the options or feel discouraged by the incredible amount of money we all hope to save for our kiddos’ education.

The important thing is to take action.  Pick a plan, decide how much you can realistically contribute without jeopardizing your own financial future, make it automatic, and forget about it.  I applaud you for being a great parent!

If you feel like you need some help evaluating all the options and deciding on the exact amount of monthly savings, I would encourage you to sign up for Ellevest Money Membership and book a session with a financial planner.