How Much Should You Save for College?

Sometimes I ask my friends with young children how much they think college will cost by the time their kids are 18. Most shrug and come up with wild guesses: "I don't know; a million dollars?" said one friend, only half jokingly.

In some ways, figuring out how much you need to save for college is trickier than deciding how much you should sock away for retirement. Most people have an idea of what their ultimate savings goal for retirement is, and given that an investor's runway to retirement is much longer (four decades in many cases), it's arguably easier to come up with reasonable estimates for market return and inflation based on historical trends.

College savings calculators (such as this free tool from Collegeboard.org) can be very helpful; however, your inputs are far from certain. To get a handle on how much you need to save, you'll need to estimate the college inflation rate and your investment return. (The other inputs, such as time until college enrollment, require less educated guesswork on our part.)

My recommendation is to use conservative estimates. A higher inflation rate and a lower return assumption will increase the amount that the calculator recommends you save. And like most tools based on time value of money equations, the calculator's output can change dramatically with only small variations in inputs. For example, using a 5% market return assumption versus a 7% market return assumption can lead some college savings calculators to suggest you save nearly 20% more, holding all other inputs equal.

Putting a Number on the Future College Inflation Rate An oft-cited assumption for college cost inflation for financial planning purposes is to use CPI inflation plus 3%, which would be around 6% as the long-term inflation averages around 3%.

But is that 6% estimate still relevant? According to yearly tuition price data from the College Board, the average annual cost of public four-year college tuition plus room and board rose 2.3% per year on average from 1987-88 to 1997-98; from 1997-98 to 2007-08 it increased 3.4% per year; and from 2007-08 to 2017-18 it rose 2.7% per year. For private colleges, from 1987-88 to 1997-98 tuition plus room and board rose 2.8% per year on average; from 1997-98 to 2007-08 it increased 2.4% per year; and from 2007-08 to 2017-18 it rose 2.2% per year.

These numbers are above CPI inflation, though. CPI inflation has varied over the past three decades: During the 1987-88 to 1997-98 period it was roughly 3.4% per year. From 1997-98 to 2007-08 it was around 2.6%, and from 2007-08 to 2017-18 it was about 1.7% per year. Because CPI inflation was lower in aggregate over the past decade, college cost inflation overall was lower: around 4.4% for public, and 3.9% for private, versus closer to 6% in previous decades.

Should we assume a lower college inflation rate going forward? This article from the "Nerd's Eye View" blog written by financial planning expert Michael Kitces and his colleague Derek Tharp argues for taking a more nuanced approach to the college inflation rate.

"According to the data in the Trends in College Pricing 2016 report (published annually by the CollegeBoard), the reality is that for students looking at private institutions, the common CPI + 3.0% inflation rate typically assumed by financial advisors has actually not been the case for some time now," writes Kitces. "Instead, the inflation rate for private colleges has been trending substantially lower for more than two decades! Yet by contrast, for high-income families looking at public institutions, a CPI + 3.0% inflation assumption for the cost of college may actually be too low!"

The article also explores the fact that college cost inflation varies based on income level of the student/family, the location of the college (inflation rates at institutions in expensive locales like San Francisco can run higher), and even by type of educational institution.

"CollegeBoard's Trends in College Pricing report provides a tremendous amount of data that advisors can (and should) use to customize their college inflation assumptions," said Kitces.

I find this argument compelling, and I think the advice is good. But I still think 6% is a reasonable place to start. Using a number lower than 6% will lead the college-savings calculator to suggest you save less, which in my opinion, is not the most conservative course.

For example, using a 6% estimate for the rate of tuition of inflation, let's estimate the future cost of college. 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 $20,000, and private (nonprofit) college was nearly $47,000 in the 2017-18 school year. In 18 years, $20,000 compounding at an annual 6% rate is more than $57,000 (around $250,000 for four years of in-state public college); $47,000 becomes more than $134,000 (around $586,000 for four years of private).

If you use a 5% estimate for college inflation, you get a total price tag of around $210,000 for four years of public college, and around $487,000 for four years of private.

Estimating Your Market Return Before you get sticker shock, remember that you receive tax benefits for 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.

Therefore, an estimate of how much your investments will return is one of the inputs you'll need to determine the amount you will need to save for college. This is a daunting task for many people (myself included). 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.

It's Better to Err on the Conservative Side The benefit of using conservative estimates 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."