When it comes to saving for college, there are a lot of options. But you don't have to be a financial expert to get started. At CollegeBacker, we've done the analysis. Starting with a 529 College Savings Plan can make your college savings go further, and we'll show you why.
In this 5-part series, we will walk through a wide variety of options, from the everyday to the esoteric. To get started, let's begin with the most common ones: savings accounts, taxed investment accounts, and 529 College Savings Plans.
As an example, let’s consider saving $100 per month from the day a child is born until their eighteenth birthday: a total investment of $21,600. How much might that investment grow?
Savings Account: $23,900
Savings accounts are the default savings method for most families and they are one of the safest ways to store money. They offer high security at the price of limited growth potential; in other words, they are stationary.
Savings accounts accrue interest, but the amount is rather minimal: the national average in 2016 is currently a mere .06% APY. If that rate continued, putting away $100 per month in a savings account would yield approximately $23,900 after eighteen years.
- Flexibility: Money in a savings account can be withdrawn at any time and used for expenses that are not college-related without penalty.
- Security: Most savings accounts are FDIC-insured, which means that the balance is guaranteed up to $250,000.
- Interest rates below inflation: The average interest rate of 0.06% APY is actually lower than the current rate of inflation (2.1% in 2016). As long as that disparity persists, any meager gains would be offset by lower purchasing power.
- Taxes: The interest generated by a savings account is considered part of your taxable income, further diminishing any gains.
Taxed Investment: $38,200
While savings accounts offer modest growth potential, investing in the stock market is likely to yield more significant returns in the long run. Investing your savings is a much more active approach.
Returns vary depending on the performance of your investment portfolio, but if stock market returns continue as they have over the past half century, investing $100/month for 18 years in a low-fee index fund could eventually yield an estimated $38,200 that could be put toward the cost of college.
- Return on investment: In the short run there are ups and downs, but over a long time horizon, investing in the market is likely to yield significant returns: between 1950 and 2009, the markets returned 7% annually.
- Freedom of choice: You have control over how your money is invested, so with the right investment guidance and adequate attention to market performance you can revise your investment strategy to maximize your savings. Furthermore, as with savings accounts, you can choose to use funds for purposes that are not related to education without paying any sort of penalty.
- Risk: Investing primarily in stocks as a child nears college is risky due to market volatility. Without carefully monitoring and adjusting your portfolio you risk endangering your returns at the very moment when you need them most.
- Taxes: Traditional stock market investments are not exempt from taxes. Taxes are levied on both dividends and capital gains.
529 Plan: $45,000
529 plans allow you to grow your investment, but they offer the added benefits of tax-free growth and tax-free withdrawals to pay for qualified college expenses such as tuition, room and board, books, and technology. If you want to be proactive, 529 plans are the greatest thing since sliced bread.
529 plans resemble tax-advantaged retirement plans, but their purpose is to save for college. Money contributed to a 529 can be invested in a diverse and dynamic portfolio, including target date funds which minimize investment risk as the beneficiary approaches college age. With the same market conditions detailed above, a regular contribution of $100/month for 18 years would eventually yield approximately $45,000 toward the cost of college.
- Tax advantages: Money in 529 plans used for college costs are exempt from federal taxes, and are typically also exempt from state taxes when used to pay for qualified education expenses. This means your investment can grow and reach its full potential without taxes eating into your returns.
- Return on investment: Although investing always involves a certain degree of risk, over time investment in a 529 plan is likely to yield significant returns. When coupled with the tax advantages noted above, 529s offer a higher expected ROI for college savings than either savings accounts or traditional stock market investments.
- Limited use: There are penalties for withdrawing the earnings to pay for non-college related expenses; specifically, taxes and a 10% penalty, if you use the funds for something other than qualified higher education costs. 529s offer quite bit of flexibility--they can be used to pay for graduate school or the education of other family members--but they are not the optimal savings method for other financial goals like retirement.
- Associated fees: 529 plans come with administration fees. Many fees are modest, especially compared with the tax benefits and investment gains, but there is still a great deal of variability between plans. All 529s are not created equal; it makes sense to choose a reliable, low-fee 529 to avoid being gouged by management fees.
While there are pros and cons to each savings option, proactive investment in a reliable 529 plan offers unique advantages when it comes to saving for college. By leveraging the tax advantages of a 529 plan and adjusting monthly contributions to meet projected college costs, you will be better prepared for the cost of higher education.
With the right guidance, getting started with a 529 plan can also be a seamless process. CollegeBacker is an SEC-registered investment adviser, and we'd love to help you navigate the complex world of college savings.
This is the first of a 5-part series comparing options to save for college.