Education Back »

Written by Carrie Johnson (former SDSU Extension Family Resource Management Specialist).

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A child’s education is one of the largest expenses many families face. College tuition and fees are increasing at a faster rate than the general rate of inflation. The sooner you start, the less money you’ll have to save per year.  Because of the time value of money (interest compounding on interest over time), a little money saved early can actually exceed a lot of money saved later on.

To estimate the cost of a college education, select a few “representative” types of schools (e.g.,—community college, state university, private college, for-profit, and “Ivy League” university) and investigate what their total costs are this year. Then multiply that cost by four years, the typical length of a college degree program. Decide how much of this cost you want to save for. Then estimate how many years are left from now until your child enters college. Multiplying the current four-year cost of colleges by the appropriate inflation factor gives you the estimated total cost of four years of education when your child is ready.

Once you’ve determined the future cost of an education at the college(s) of your choice, complete the balance of the worksheet to determine how much you need to save for each child on an annual and a monthly basis.

In addition to making decisions about specific investment products, it is also important to consider the effects of tax laws when saving or investing for your child’s education. Any unearned income (interest, dividends, capital gains) received by a child under age 24 if in college or under age 19 otherwise, over an annually-adjusted amount, is taxed at his or her parents’ generally-higher marginal tax rate. This is the so-called “kiddie tax”, which reduces the tax benefits of shifting income to pre-teenage children.

Some parents also wonder if saving will make their child ineligible for future college financial aid. It might—a classic “catch 22” situation. Generally speaking, the more income and assets a family has, the less financial aid they may be eligible for.  Special strategies such as the use of tax-deferred retirement savings plans (the amount contributed does not count as available income) or a home equity loan or refinanced mortgage (mortgage debt counts in the needs analysis formula) can be used, however, to increase the chances of qualifying for assistance.

On the other hand, there are no guarantees of financial aid. If money is not saved, parents run the risk of not being able to send their child to college or having to take out expensive loans if no financial aid is available. The safest course of action is to plan to contribute a specific amount toward your child’s education and to begin saving for it as soon as possible.

Smart Tip

Regardless of income, parents and students should research—and exhaust—federal student loan options before turning to private loans. Not all federal student loans are based on demonstrated financial need. Ultimately, if you apply for a federal student loan, you will need to complete a FAFSA form.

Tips for Choosing College Savings Options

1. Understand the Tax Benefits
A number of college savings options offer tax-advantaged ways to save. Taking advantage of these savings options may greatly affect how much you can accumulate for your child’s college education. In addition to the federal tax benefits of many college savings options, there may also be state tax benefits. Savings bonds are usually exempt from state and local taxes. Many states allow you to deduct some or all of your contributions to a 529 plan if you’re a resident of the state sponsoring the plan. In addition, states may offer other tax advantages for 529 plans. Because of these state tax benefits, you might want to check out your own state’s 529 plan before considering other plans. Everyone’s tax situation is different, and state and federal tax law can be complex. You may want to consult with your tax adviser about which college savings options are best for you.

2. Examine Fees and Expenses
Most college savings options involve various fees and expenses. A college saving option with higher costs must perform better than a low-cost option to generate the same returns for you. Even small differences in fees and expenses can translate into a large difference over time. If you invest in mutual funds through an ESA or custodial account, you should check the fee table in the prospectus to see how the costs of a mutual fund add up over time. If you invest in stock, make sure you understand how much in commissions you must pay and factor this into any gain you may make.

3. Know the Risks As Well As the Rewards of Your College Savings Options
Compared to saving for retirement, your college saving timeline is relatively short. At most, it may be 18 years. And for many people, it’s a lot less. This can impact your ability to weather a market decline and increases your risk.

4. Understand Your College Savings Plan’s Limitations and Restrictions
What happens to your college savings if your child decides not to go to college, you have another child or you lose your job? These events and many others could dramatically impact your college savings strategy.  Unfortunately, most college savings options have various restrictions and limitations that may impact your ability to react to a changing situation. Review carefully any college saving options you’re considering to make sure they have the flexibility and control you feel you need.

College Savings Plans Comparison

  Coverdell ESA 529: Prepaid Tuition 529: Savings Plan Roth IRA
Summary Investment account for those who earn less than $110,000 (single filers) and $220,000 (joint filers). Contributions must stop when the child reaches the age of 18. State-sponsored program that are guaranteed to increase in value at the same rate as college tuition. So, if you pay invest one year of college tuition today, 10 years from now it will pay for one year of college tuition. State-sponsored investment account to benefit anyone (does not have to be a family member). Retirement account that can be used for college expenses for you, your spouse, children, or grandchildren.
Contribution Limit $2,000 per year Depends on the plan and age of student (typically $50,000 to $100,000) Depends on the plan (ranges from $235,000 to $400,000) $5,500 per year ($6,500/year if you are over 50 or older)
Qualified Expenses Tuition, fees, books, supplies, equipment, room and board. For room and board, the student must be residing in housing owned or operated by the school. Tuition at a college within the plan. Tuition, fees, room, and board Tuition, fees, books, supplies, and equipment
Tax Benefits Contributions are not tax free, but amounts deposited grow tax free and distributions for qualified educational expenses are tax free. Depends on the state. Contributions can be partially or completely deductible. Disbursements are tax-free if used for qualified expenses. Contributions are not deductible, but earnings grow tax free. Although can be used as an estate tax planning tool and money can be gifted. Disbursements are tax-free if used for qualified expenses. Disbursements are tax free if used for qualified educational expenses.
Effect on Federal Financial Aid Used in the financial aid calculation, considered to be an asset of the student. Considered to be student resource and will reduce financial aid. Considered to be property of the account owner. Money in the account does not affect aid eligibility. Distributions are considered income.
Transfer Options Can be transferred to another immediate family member with no tax consequences if the new beneficiary is under age 30. Can be transferred to another immediate family member. Can be transferred to another immediate family member. No real transfer option. Can have a Roth IRA in either the adult’s name and/or student(s).
Penalty for non-qualified withdrawals Taxed as ordinary income to contributor, plus a 10% penalty. Taxed as ordinary income to contributor, plus a 10% penalty. Taxed as ordinary income to contributor, plus a 10% penalty. Taxed as ordinary income to contributor, plus a 10% penalty. If withdrawals are taken after the age 59 1/2 , no tax or penalty.


Useful Websites

  • FAFSA (Free Application for Federal Student Aid): Contains information about filing the federal FAFSA form to apply for student financial aid.
  • Federal Student Aid: Get ready for college or career school, learn about federal student aid and how to apply, and get information on repaying student loans.
  • SD Opportunity Scholarship: The South Dakota Opportunity Scholarship provides $5,000 over four years to a qualifying student who attends an eligible higher education institution in South Dakota.
  • FinAid: This website is a comprehensive one-stop resource for information about college financial aid and savings plans.
  • Saving for College: Learn about 529 plans, grants and scholarships, and student loans. 
  • I Savings Bonds: Use I Bonds to save in a low-risk product that helps protect your savings from inflation.
  • EE Savings Bonds: Use EE Bonds to save in a reliable, low-risk, government-backed product.
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