How to Invest for Your Kid’s College Today

Everyone knows that college isn’t cheap, but do you have any idea how expensive higher education actually is? Average in-state yearly tuition at a public four-year university is about $10,230, and an in-state private institution costs about $35,830, according to a report by College Board. These costs will continue rising in the future, and they don’t include room and board, either.

If you’re wondering how on earth you’re going to help pay for your child’s future college education, you aren’t alone. Let’s face it, many of us were already hard hit by student loans ourselves. The last thing we want is for our kids to start out their careers seriously in debt.

The key thing is even if it’s just $10 a month, it’s important to start today. While it’s easy to put off the monumental task, starting early can set you up for financial success. Here’s how.

The Impact of Investing Money for College Early

The impact of investing early for a child’s future college education costs is huge, thanks to two major factors. First, the earlier you start contributing, the more money you can contribute. This seems obvious, but it’s really important because college isn’t cheap.

The more time you have to build up enough savings for future expenses, the better.

And here is where we get into the beauty of compound interest. By starting early, you allow your money to grow for a longer period. In the first year, your money will earn returns. In the second year, those returns from the first year will now be part of your starting balance in Year 2 and will earn additional returns. Compounding returns allow your money to grow to larger amounts the longer you can leave your money invested.

The Effects of Compounding Interest

Here’s a quick example that shows the impact of when you start investing for your child’s college education. The example assumes that you start investing on the child’s birthday of the stated year and that you invest $250 per month, every month until your child turns 18, with 8 percent returns. The numbers were calculated using Dave Ramsey’s online investment calculator.

Ways to Start Investing for College

In theory, you could start investing for college in a run-of-the-mill taxable investment account.

However, there are also specific savings vehicles that help you invest money for education expenses. Plus, there are other accounts that aren’t specifically for education expenses, but that people frequently use for that purpose, anyway. Below is a high-level overview of each type of account. Check it out to see if one of them may be a good fit for your college savings.

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1. Coverdell Education Savings Accounts (ESAs)

Coverdell Education Savings Accounts (ESAs) used to be called education IRAs. These accounts allow anyone to invest up to $2,000 per year per beneficiary as long as the beneficiary is under 18 and you don’t exceed income limitations.

The key is that only $2,000 can be contributed per beneficiary, no matter who makes the contribution.

ESAs don’t give you a tax deduction for contributions, but they do allow your investments to grow tax-free as long as you use the money for qualified elementary, secondary, or college education expenses.

If you don’t use the money for a qualified expense, you’ll have to pay ordinary income tax on the earnings, plus a 10 percent penalty. Ouch!

You can open an ESA at most major brokerages, so you can shop around to find an account that offers low fees on the investments you want to invest in.

These accounts are considered parental assets. This classification is better than the assets belonging to the child for federal financial aid calculations. If the child doesn’t use the funds by age 30, you must either distribute the money or roll it over to another child.

2. 529 Plans

One of the most popular college savings options is the 529 plan.

“I prefer 529 plans to a Coverdell ESA,” says R.J. Weiss, certified financial planner and founder of The Ways to Wealth. With 529 savings plans, you can set money aside without paying income taxes on investment earnings, as long as you use the money for qualified education expenses.

Although 529 savings plans don’t have contribution limits, states might set a maximum balance you can accumulate in their plans.

They also count as parental assets when calculating expected family contribution.

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Different Options

Each state runs its own 529 plans, and you can usually pick any state’s plan you want. Typically, you don’t have to live in or plan to attend college in the state whose plan you invest in. This is important because each state’s plan may be run by different companies, offer different investment options, and charge different fees. Finding a low-cost 529 savings plan can help you keep more of the money you invest.

“Not only can your money grow tax-free using a 529 plan, but in many states, you’re allowed to take a state tax deduction in the year you contribute,” Weiss says.

In order to get the tax deduction, you may have to invest in a certain state’s 529 plan. Each state’s plans have different benefits and fees, so make sure to find the best plan for your situation.

“One underappreciated aspect of 529 plans is how flexible they are,” Weiss adds.

“You can change the beneficiary of a 529 plan or change the owner without tax consequences. This makes them ideal for growing families or for those who are unsure about their future education plans.”

If you use the money for costs other than qualified education expenses, you’ll have to pay ordinary income tax on the earnings and a 10 percent penalty in most cases.

3. Prepaid College Tuition Plans

With 529 plans, you have another option: prepaid college tuition plans. These plans allow you to buy chunks of tuition at current rates and use them in the future.

Unfortunately, few states offer these plans, and they come with many restrictions. For instance, you may have to be a state resident to use these plans. Plus, getting the maximum value is usually only possible by attending public, in-state colleges.

4. Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) Accounts

UGMA and UTMA accounts are a way to transfer assets to minors without setting up a trust. These accounts aren’t specifically designed to help pay for college expenses. However, many parents and grandparents use them for this purpose.

You can open these custodial accounts at most major brokerages and can invest in stocks, bonds, mutual funds, and exchange-traded funds (ETFs), among other options. They don’t have contribution limits.

Drawbacks

It’s important to note that any assets are the property of minors. This is a negative when calculating the expected family contribution for federal financial aid, since children’s assets are expected to be used at a higher rate to pay for college than a parent’s assets are.

Additionally, children will gain access to the assets in these accounts when they reach the age of majority according to your state’s UGMA or UTMA laws. This is usually 18 or 21. They can use the money for anything, so they could blow it on a motorcycle rather than use the money to pay for college, as you intended.

Final Tip on How to Invest for College

If you have children and you plan to help pay for college, start investing money for it as soon as possible. Find a way to invest that makes the most sense for your family and act. When your child attends college, you’ll be glad you started investing early.