How Much Should You Save for College?
Let's put a number on how much it could cost, and how much you might need to save.
Saving for college is a daunting task. One of the difficulties is coming up with a reasonable estimate of what it will cost by the time your child is ready. There are other unknowns, too, like, how much help can you count on from the markets between now and the time your child is 18? How much will you need to set aside every year?
Let's say you have a new baby in your family. (Congratulations!) You received $5,000 in cash as gifts from very generous friends and relatives, and you used it to start a 529 college savings plan account. (How very prudent of you.) Let's say you want to save enough to cover four years of tuition and room and board for your bundle of joy at an in-state public school. How much should you aim to save every year make this goal a reality someday?
How Much Will It Cost?
To try to come up with a reasonable estimate of the future price, let's start with what college costs now. According to data from the College Board, the average cost of a year of tuition plus room and board for an in-state student at a public university was over $19,500, and private (nonprofit) college was nearly $44,000 in the 2015-16 school year.
For the rate of tuition inflation, I'm going to use a 6% yearly average. How did I come up with that? Is it just a guess? (Honestly, yes, but it's an educated one.)
According to yearly tuition price data from the College Board (and my own calculations), the average annual cost of public four-year college tuition plus room and board rose 5.7% per year on average from 1985-86 to 1995-96; from 1995-96 to 2005-06 it increased 5.7% per year; and from 2005-06 to 2015-16 it rose 5.1% per year. For private colleges, from 1985-86 to 1995-96 tuition rose 6.8% per year on average; from 1995-96 to 2005-06 it increased 5.2% per year; and from 2005-06 to 2015-16 it rose 4.4% per year.
As you can see, the rate of tuition inflation has been in the range of 4.4% to 6.8% per year. Somewhere in the realm of 5%-6% seems like a reasonable estimate of how much it will increase per year going forward, with 6% being the more conservative assumption. (You can use a higher or lower rate in your assumptions.)
Using our 6% estimate for the rate tuition of inflation, we can now estimate the future cost of college. In 18 years, $19,500 compounding at an annual 6% rate is nearly $55,660 (more than $243,000 for four years of in-state public college); $44,000 becomes more than $125,500 (around $550,000 for four years of private).
Before you get sticker shock, remember that these estimates do not take into consideration grant aid and tax benefits of saving for college within tax-sheltered vehicles like 529s. And also remember that the return on your investments can take you part of the way.
But also remember, the benefit in estimating this conservatively (or anticipating that it will cost more) is that it raises the bar for how much you need to save. As Morningstar director of personal finance Christine Benz says, though a more pessimistic forecast will necessitate saving more, "most investors would rather risk a happy surplus than fall short."
How Much Should I Plan to Set Aside Per Year?
To find a yearly savings target, let's move on to our College Savings Calculator.
The good thing about this calculator is that it's simple but customizable, so it can take into account how much you've saved so far and how long you have to go until your child starts college. The bad thing is you have to come up with an estimate of how much your investments will return over that time frame, which can induce many people (myself included) to engage in some shoulder-shrugging behavior. But, let's try to come up with a reasonable estimate anyway. (And if you disagree, you can input your own rate of return.)
Long-term historical averages for the S&P 500 are around 7% (inflation-adjusted), including reinvested dividends. But it may be wise to give this a little haircut over the next 18 years or less, considering that many experts predict lower growth for the stock market in the years ahead. In addition, if you're using a 529 college savings plan, your allocation to equities starts out more aggressive when the college start date is more than a decade away, and becomes more conservative (with a much higher allocation to cash and fixed income) leading up to and while the student is enrolled in college.
Our calculator uses 5% growth (real) as a default. If, like me, you think that's reasonable, go with it. If you want to adjust it higher, go ahead; just be aware that doing so will lower the amount the calculator suggests that you save, which could cause a savings shortfall if these market returns do not come to pass.
The calculator also asks for a return for your savings during the years your child is enrolled in college. The default is 2%; though that seems like an overestimate in the current low-yield environment, historical three-month Treasury bill yields exceed 3%, so it's actually not a bad estimate.
Putting It All Together
Now let's take everything we've come up with and plug it in to determine a yearly savings estimate. Remember, your goal is to save enough to pay for your child to go to an in-state public school in 18 years. Inputting the $5,000 you already have saved, and using the assumptions for tuition inflation (6%) and investment returns that we've come up with (5% before college; 2% during college), the calculator tells us that we should save about $7,900 per year to get to our goal of around $243,000 for four years of in-state public college tuition plus room and board.
Of course that's a heavy lift. Every little bit you can sock away helps--cash gifts from friends and relatives, yearly work bonuses, and tax refunds, if you're lucky enough to get them, will go a long way. And remember that the earlier you contribute money to a college savings plan, the longer it will compound tax-free, which argues for putting money away for college sooner rather than later.
But also keep in mind that it's important to balance college savings with other financial goals, such as saving for retirement, building an adequate emergency fund, and paying down debt. This article can help you prioritize.