As you approach your 30’s and 40’s, life starts to change pretty quickly. You go from just caring about yourself to now wanting the absolute best for your family and children. One of the most common goals I hear from parents is that they simply want to give their children a better life than the one they have had. Besides travel and experiences, education is the best way to provide them with a better life, the problem is that education is so expensive. Here is the breakdown of what college could cost per year (U.S. News):
- 4 year in state college cost: $39,000
- 4 year out of state college cost: $85,000
- 4 year private university cost $140,000
Those numbers are overwhelming already without even talking about inflation, which according to finaid.org is somewhere close to 8% a year for college expenses. That means that education costs nearly double every 9 years. Insane 🤯, I know.
Now that we know it’s expensive, which you probably already knew, how do you go about saving for college? In order to determine the right mix, we will look at the good and the bad of:
- 529 Plans
- Taxable Investment Accounts
- Use of Cash Flow
The one thing we will not talk about in this post is loans, loans are an option if you have a short fall, but for this post we are going to look at how to save and use these accounts together.
529 plans are the most talked about way to save for college because these plans are specifically created to be used towards educational expenses, similarly to how a ROTH IRA is made to be used for retirement.
529 Plans are tax advantaged savings plans for educational expenses in the future and are sponsored by states. Determining to use one is really up to you and understanding the benefits and negatives seen below.
Note: some states’ 529 plans offer more advantageous tax benefits than others which could push you to use the plan in one state but not in another. For example, In Indiana, you receive a 20% tax credit for 529 plan contributions, but that stops at $5,000. This means that if you put $5,000 into a 529 plan per year, you receive a state tax credit of $1,000 (that’s a pretty great benefit). However, if you put above $5,000 in, you will still only receive that $1,000 state tax credit.
One reason people argue about whether to use a 529 plan is because of the chance their child does not go to school/receives a scholarship. If this were to happen, which it does happen often, the earnings of a non-qualified 529 plan distribution is subject to income tax and a 10% penalty when used for non education purposes — but should that stop you from using a 529 plan? Probably not. A 10% penalty may not be ideal, but it also is not that awful of a penalty if you do not have to pay for college.
Taxable Investment Account
Taxable investment accounts are accounts that you use to invest in, but come with no tax advantages. However, because of the lack of tax benefits, you can use this account for whatever you want, whenever you want. You just need to be aware that you will be taxed on dividends at your income rate and taxed on capital gains at either short term or long term capital gains rates. Read more about personal taxes here.
With a taxable investment account, there are some strategies to use like tax loss harvesting that might help with the tax implications, however it still will not be as tax efficient as a 529 plan.
The advantage of saving in this account is that if your children do not go to college, there is no penalty at all, but because of the way it is taxed (lack of tax deferred growth) the value in this account could potentially be less than if it were in a 529 plan. Another advantage is that with taxable investment accounts you have unlimited investment opportunities compared to 529 plans that are limited in what you can invest in.
Another option people choose is to use their cash flow to pay for college monthly. This is an option that can work, but if this is how you are trying to pay for all of college, you will need to have a large salary that is not already being used on other expenses. It could be anywhere from $1,000-$5,000 a month if you are trying to fund all of college through cash flow.
If the parents saved well for retirement while they were young, they may be able to scale back on retirement savings for a few years to create more free cash flow that could be used to fund college. Then, once the college savings are done, they could go back and ramp up retirement savings again. Saving early creates these options for you later on in life to pursue other goals.
Should You Use Entirely One Account Or A Combination?
As you can see, there are benefits and negatives to using each one of these accounts, but no one ever said you have to fund college entirely through just one. In many situations, it makes sense to combine many of these strategies to give you options. For Indiana people, it may make sense to contribute the $5,000 a year to get the 20% tax credit, then invest in a taxable investment account to help supplement the rest. Then, if you end up with any shortfall, use cash flow to make up whatever is left, or take out a loan for the rest.
There really is not one correct answer, and it can even vary from state to state based on tax benefits of the plan. Consult your CPA and financial advisor to come up with a strategy that fits best for you and your family, but also understand that this decision would be way easier if you knew the future. We just have no idea what college could look like at that time, and we also have no idea if our children will get a scholarship, go to trade school, or even just start their own business — but if we did, it would obviously make the decision way easier.
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Disclaimer: Nothing on this blog should be considered advice, or recommendations. If you have questions pertaining to your individual situation you should consult your financial advisor. For all of the disclaimers, please see my disclaimers page.