A College-Savings Checklist
Whatever the student's age, planning ahead is critical, and these five steps can help.
Note: This article is part of Morningstar's October 2014 College Planning Report Card special report.
Given the many different financial responsibilities on parents' plates--paying the mortgage or rent, providing food and clothing for their families, paying utility and insurance bills, saving for their own retirements, and so on--it's no great surprise that saving for college sometimes gets short shrift. Maybe you look at your depleted bank account at the end of each month and tell yourself you'll start later--after all, you still have plenty of time, right? But every day you put off saving for college is a lost opportunity to start tackling what, for many families, is among their most important and expensive financial goals. That's one reason why having a plan is so important.
Wherever you are on the college planning timeline--whether your child is in diapers or soon to get his or her high school diploma--there are key steps along the way that can help keep you on the right path. Here are some ideas for savers just starting out, as well as for savers with children who are getting close to college age.
Just Starting Out
Step 1: Determine Your Goal: You've decided to start saving for college and that's great, but this is also the time to think about what you're trying to accomplish. Do you plan to fund all of your child's college education? Half? Just a small portion while borrowing the rest? How much do you expect your child to pay? The answers to these questions can inform your saving rate as you move forward.
Obviously, the more college costs you hope to cover, the more you'll need to save; but how can you figure out how much that is? Try out various online college-savings calculators, such as the one here at Morningstar.com, or this one from Vanguard. College may be a long way off, and you may have no idea what type of school--public or private--your child will attend, let alone what area of study he or she may pursue. So, it might not be a bad idea to enter figures for several different scenarios into one of these calculators to get an idea of how much costs might vary.
Step 2: Determine Your Vehicle: If how much you save for college matters most, how you choose to save probably ranks second. College savers have a variety of options, from bank savings accounts to taxable mutual fund or brokerage accounts to tax-advantaged accounts, such as 529 college-savings plans and Coverdell Education Savings Accounts. For more on various college-savings vehicles, watch this video. Below are some of the pros and cons of each.
Bank savings account
Pros: Highly liquid, FDIC-insured
Cons: Low rate of interest unlikely to keep up with tuition inflation, income is taxable
Taxable mutual fund or brokerage account
Pros: Wide range of investing options with the potential to outpace tuition inflation, especially if invested in stocks; money remains relatively liquid
Cons: Potential to lose money if markets take a downturn, gains and income are taxable
UGMA/UTMA (custodial account)
Pros: Wide range of investing options; gains and income taxed at beneficiary's rate, which is often lower than if owned by the parents
Cons: Can have a negative effect on financial aid; after age 18 or 21 (depending on the state), beneficiary may choose not to use the money for college
529 college-savings account
Pros: Gains and distributions are tax-free if used for qualified college expenses; many states offer a tax break on contributions to in-state plans; potential to outpace tuition inflation
Cons: Investment options limited, fees can be higher than investing outside the plan, potential to lose money if markets head south
529 prepaid tuition plan
Pros: Locks in tomorrow's tuition costs at today's rates; account grows tax-free; contributions may be deductible on state income taxes
Cons: Forgoes higher return potential of stocks; only offered in 12 states (plus private colleges); not all states fully guarantee plan funding
Step 3: Save, Save, Save: It may sound obvious, but it's still worth remembering. The more you save now, the less you'll need later and--most significantly--the less you or your child will have to borrow down the line. Even if you can't save enough to pay the full cost of college, every little bit helps. As an example, the parents of a newborn who contribute $100 a month to an account averaging 5% annual returns will have saved about $35,000 by the time the child reaches age 18.
If you're not sure you have the financial discipline to save each month, consider signing up for automated monthly contributions to your college-savings account. Also, consider coordinating with grandparents and any other relatives or friends who may want to contribute to saving for the child's college years.
Within a Few Years of College
Step 4: Understand Financial Aid: With college years in sight, start educating yourself about how financial aid works. It's a complicated process, so the more you know in advance, the better your chances of maximizing grants and scholarships for your child. For example, need-based financial aid formulas penalize student-owned assets more heavily than parent-owned assets, so getting assets out of the child's name and/or spending down some parental assets or deferring income can help improve the financial aid award. Also, make sure you understand the difference between need-based aid, which is calculated according to the student's financial situation, and merit-based aid, which is awarded based on other factors.
Be aware that need-based financial aid eligibility for incoming freshmen is based on the family's financial situation during the last full calendar year before enrollment--that is, the year that ends his or her junior year of high school and begins senior year. So, plan accordingly. Watch this video to hear about strategies that can improve your odds of receiving financial aid and this one to learn about common mistakes people make when filling out the Free Application for Federal Student Aid (FAFSA). If you or your student plan to borrow to pay for college, make sure you understand the differences between federal and private loans and estimate how much you can realistically afford to borrow (don't let the lender determine this for you).
Step 5: Research Schools Thoroughly: It's easy to focus on school rankings and other simplistic measures when deciding which college to attend, but a true cost-benefit analysis is in order. That means taking into account not only the published cost of tuition but the average net tuition students pay once financial aid is factored in. Other considerations include the college's graduation rate and the percentage of student borrowers who default on their loans. You can find this information and more on the U.S. Department of Education's College Navigator website or on the White House's College Scorecard website.
Don't be afraid to ask schools questions about where their graduates are now and about career-placement resources. And don't assume that a more expensive school is always worth the added cost. Paying much more in tuition for a marginal step up in quality--especially if it will require you to borrow more--may not be your best move.