With the increasing cost of college, there has been much debate in the mainstream media recently as to whether a college degree is even worth the expense. Yet even as recently as 2 years ago, economists have determined that those with a bachelor’s degree still out earn their high school diploma peers by $1.2 million over their lifetimes. An analysis of that study in Forbes recently, made the figure a bit more tangible: a bachelor’s degree was the difference between making $70,000 a year on average versus $40,000 a year on average for someone who only graduated high school over a 40 year period. Professional degrees on average brought that figure to $117,500.
Given these figures, a calculation with a few assumptions can tell us if it is still worth the money. According to the Best Colleges, the average net cost for a 4 year private non-profit school was $28,050 in 2021, which comes to $112,200 over the course of 4 years. If we assume all that is borrowed at a subsidized rate of 6%, the 4 years lost that could have been spent working, then the difference in earnings is still produces $960,000 more in lifetime earnings. That figure jumps to $2.3 million more earned over a lifetime net with a professional degree.
College is clearly still worth it in terms of pure dollars and cents, but the question then becomes for those parents who don’t want their children saddled with student debt, what is the best way to save in a tax efficient manner?
With the rising costs of tuition, room and board, and other associated expenses, planning for a child’s higher education requires a strategic approach. In this post, we will explore a comprehensive strategy that leverages the benefits of a 529 plan, an Educational Savings Account (ESA), and personal funds to maximize tax savings over an 18-year time horizon. We are going the highest level average cost of $42,000 for a private college education today, adjusted for an annual inflation rate of 2%. We will outline the estimated amount needed in 18 years and discuss the advantages of each savings vehicle.
529 Plans: A Cornerstone for College Savings
529 plans are tax-advantaged savings vehicles designed to encourage families to save for future education costs. These plans are sponsored by states, state agencies, or educational institutions and offer significant tax benefits. Contributions to a 529 plan are made with after-tax dollars, and while they are not deductible on the federal level, some states offer state income tax deductions for contributions.
One of the primary advantages of 529 plans is their tax-free growth potential. Earnings within the plan are not subject to federal income tax as long as the funds are used for qualified education expenses. These expenses include tuition, room and board, books, and other mandatory fees at eligible institutions. Furthermore, recent legislative changes allow for tax-free withdrawals of up to $10,000 per year per beneficiary for K-12 education expenses.
Any individual, regardless of income, can contribute to a 529 plan, and there are no age restrictions for the beneficiary. This flexibility makes 529 plans an attractive option for parents, grandparents, or other relatives looking to contribute to a child’s education fund.
However, 529 plans do have a downside. These funds cannot be included for common expenses such as travel to and from school and non-mandatory items such as a computer. They also are subject to state rules that usually limit the investment options to broad index funds like those offered by Vanguard. Investments can often only be changed once a year. An Educational Savings Account can help fill the gap in both options and costs.
Educational Savings Accounts (ESAs): Another Tax-Efficient Tool
Educational Savings Accounts, also known as Coverdell ESAs, provide another avenue for tax-advantaged education savings. ESAs are similar to 529 plans in that contributions are made with after-tax dollars, but they offer greater flexibility in terms of investment options. ESAs allow for a range of investment choices, including individual stocks, bonds, and mutual funds.
Contributions to a Coverdell ESA are limited to $2,000 per year per beneficiary, and there are income restrictions on contributors. Single filers with a modified adjusted gross income (MAGI) above $110,000 and joint filers above $220,000 are ineligible to contribute to an ESA. However, these limitations may not apply to grandparents or other family members who wish to make contributions.
Like 529 plans, the growth within an ESA is tax-free, and withdrawals are also tax-free when used for qualified education expenses. Qualified expenses include not only higher education costs but also K-12 expenses, making ESAs a versatile option for families planning for both private school and college.
The flexibility here is the key. ESA funds can be used to pay for flights or gas to and from school, for that laptop they will surely need or cap and gown at graduation.
Personal Funds: Bridging the Gap
While 529 plans and ESAs offer valuable tax advantages, personal funds should not be overlooked as a crucial component of a comprehensive college funding strategy. Personal funds can be used to cover any education-related expenses that may not be fully covered by 529 plans or ESAs such as small cash accounts for groceries and other emergencies.
Personal funds can include savings accounts, investments, or any other liquid assets that a family allocates for educational purposes. While these funds do not provide the same tax advantages as 529 plans and ESAs, they offer flexibility and liquidity. Personal funds can be particularly useful for covering miscellaneous expenses, such as personal items, or unexpected costs that may arise during a college education.
Estimating the Total Cost in 18 Years
To determine the amount needed for a child’s college education in 18 years, we start with the current net cost of a private college education, which is approximately $42,000. Assuming an annual inflation rate of 2%, we can calculate the future cost using the formula:
Future Cost=Current Cost×(1+Inflation Rate)Number of Years
Using this formula, the estimated future cost of a private college education in 18 years would be:
$42,000×(1+0.02)18≈$58,015.23
Therefore, to cover the estimated future cost of a private college education in 18 years, we would need to plan for approximately $58,015.23 per year.
If we assume a 7% growth rate invested in an aggressive index fund consisting of mostly stocks and some bonds, this translates to saving approximately $600 per month per child over the course of 17 years until they attend college at 18.
Maximizing Tax Savings: A Holistic Approach
To maximize tax savings over the 18-year time horizon, it is crucial to allocate contributions strategically among 529 plans, ESAs, and personal funds. Here’s a suggested approach:
- 529 Plans:
- Contribute an amount that aligns with state income tax deductions, if available.
- Front-load contributions when possible to maximize potential investment growth.
- ESAs:
- Contribute up to the $2,000 annual limit per beneficiary.
- Utilize the flexibility of investment options to optimize returns.
- If you exceed the income limit, use friends and family to open the account and control can then be directed by the parents.
- Personal Funds:
- Maintain personal funds as a flexible resource for miscellaneous expenses and as a safety net for unforeseen circumstances.
By adopting this three-pronged approach, families can take advantage of the unique benefits offered by each savings vehicle, optimizing tax efficiency and ensuring comprehensive coverage of future education costs.
Conclusion
Paying for a child’s college education requires foresight, planning, and a well-executed strategy. By leveraging the tax advantages of 529 plans and ESAs while strategically utilizing personal funds, families can create a robust financial plan that addresses the rising costs of higher education. The estimated future cost of a private college education in 18 years, factoring in a 2% annual inflation rate, emphasizes the importance of early and consistent savings.
It is essential for families to regularly review and adjust their savings strategy, taking into account changes in financial circumstances, investment performance, and any adjustments to education-related expenses. With a comprehensive and adaptable plan, families can navigate the complexities of college funding and provide their children with the opportunity for a quality education without undue financial strain.
The information provided by www.cashchronicles.com is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs. www.cashchronicles.com does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any tax or investment decision without first consulting his or her own financial advisor or accountant and conducting his or her own research and due diligence. To the maximum extent permitted by law, www.cashchronicles.com disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses. Content contained on or made available through the website is not intended to and does not constitute legal advice or investment advice and no attorney-client relationship is formed. Your use of the information on the website or materials linked from the Web is at your own risk.