New Baby? Start Budgeting for College

Starting a family can affect household finances in many ways. Generally speaking, the monthly budget increases because of additional doctor visits, food, clothing and, of course, diapers. The need for life insurance and estate planning also increases, given the added financial responsibility that kids bring. Once children are in the picture, near the top of any new parent’s to-do list is saving for college.

With the cost of college tuition increasing at a rate higher than inflation, the amount estimated to be needed 18 years from now for a four-year public university can easily top $150,000. There are a couple of approaches to saving for college:

A. Determine the future value of an average four-year public or private institution and discount that value back to
present-day dollars, using a reasonable estimate for market returns, or 

B. Save any amount of household cash flow that you can afford until the day the funds are needed for college expenses.

Choice A, budgeting cash flow to fund a targeted liability, is the preferred approach. But this can mean setting aside cash that the budget does not currently allow after all other expenses are factored in. Whether or not your goal is to pay all or some of your child’s college tuition, either option listed above is better than doing nothing. Savings through a 529 account can offer tax advantages on the investment earnings when used for qualified education expenses.

Specifically, when you save in 529 accounts, the deposits are made after-tax. When you eventually withdraw funds and they are used to pay for qualified education expenses, however, the earnings come out tax-free. So, while Choice A in the previous paragraph may be superior to Choice B, Choice B is far, far superior to doing nothing. Saving early over 18 years can mean large earnings owing to compounding. As a quote often attributed to Albert Einstein goes, “Compound interest is the eighth wonder of the world” — he who understands it, earns it. He who doesn’t, pays it.

Points to Consider

There are a few highlights worth mentioning when evaluating 529 accounts. Already stated is the tax benefit of the investment growth when funds are used to pay for qualified education expenses. In addition, some states offer tax deductions or credits for contributions to 529 plans. The tax benefits alone are an increased incentive to start saving sooner rather than later.

529 accounts also offer control to the account owner, unlike UGMA/UTMA (Uniform Gift to Minors Act/Uniform Transfer to Minors Act) accounts, where the child gets control of the account once he or she reaches legal age. As the parent/grandparent, this helps to ensure that the funds are used for their intended purpose.

As the owner, you can also change the beneficiary of the 529 account. For example, if one child does not use all the funds in the account, you could change the beneficiary to fund the education of a sibling or grandchild. The funds can be accessed at any time for reasons other than education expenses — however, the investment earnings in the account will incur income tax in addition to a 10% penalty.

The new tax plan, effective Jan. 1, 2018, now allows for qualified withdrawals from 529 plans of up to $10,000 (per student) in tuition for attendance at public, private or religious elementary or secondary schools. It’s worth mentioning that change applies to federal tax; consult with your CPA to understand your specific state’s tax treatment.

Although I’ve spent time talking about 529 college savings plans, it’s important to do your own due diligence or consult with your adviser to see what savings vehicle makes the most sense for your situation. As with any investment, understand the cost and how the account can be managed. Also, compare more than one plan to understand what’s best for your family.

No matter what plan you choose, at least you’ll be doing something. It’s far better to start saving something rather than doing nothing!

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