The Most Common College Savings Mistakes
It is cheaper to save than to borrow, but many parents do not save for their child’s college education. Even among the parents who do save, most do not save enough. Other parents make mistakes when deciding when to start saving, how to invest college savings and how to use the money in the college savings plan.
Mistakes about Whether to Save for College
Failing to save for college. Parents give many reasons for not saving for college. Sometimes they suffer sticker shock at the prospect of saving 100 percent of college costs. Sometimes they argue that there is a penalty for savings in college financial aid formulas. Sometimes they think that financial aid will cover all college costs or that their child will win a free ride through scholarships. Other times they prioritize saving for retirement ahead of saving for college.
- Rather than try to save the full cost of a college education, families should spread the cost of college out over time, just as they would do for any other major life-cycle expense. As a rough cut, one third of college costs should come from past income (savings), one third from current income and one third from future income (loans). Aiming to save about a third of future college costs (or, equivalently, the full cost of a college education the year the child was born), will get you into the right ballpark.
- There is a penalty for college savings, but it is a small penalty. If you save in the parent’s name or in a 529 college savings plan, need-based financial aid will be reduced by at most 5.64 percent of the asset value. So, for every $10,000 saved, you will still net $9,436 to pay for college costs.
- Financial aid will not cover all college costs. Most colleges do not meet full demonstrated financial need. Even among those colleges that meet full need, most include student loans in the financial aid package. Only 35 colleges (out of thousands) meet full need entirely with grants, and many of these colleges do so by redefining financial need. Only about 0.6 percent of students receive enough grants and scholarships to cover all college costs.
- Parents who save for college and for retirement end up with more money in retirement than parents who only save for retirement. Saving for college avoids the need to borrow high-interest debt to pay for college. The optimal strategy is first to maximize the employer match on contributions to your retirement plan, since that’s free money. Then, take a balanced approach of saving for both college and retirement.
Saving for college provides several benefits, such as increased flexibility and less debt. Families who save for college can choose a more expensive college than they otherwise could afford. College savings also can reduce student loan debt, since every dollar you save is about a dollar less you’ll have to borrow.
Mistakes about When to Save for College
Waiting to start saving for college. Some families wait until their child enters high school to start saving for college. If you wait until high school to start saving for college, less than 10 percent of the college savings goal will come from earnings, compared with about a third if you start saving when the baby is born. You’ll also need to save six times as much per month to reach the same college savings goal. Time is your greatest asset because it provides the opportunity for your investments to grow.
Mistakes about How Much to Save for College
Not saving enough. Only about half of parents are currently saving for their children’s college education. These parents typically save enough for less than a year of college, when they should be aiming for about 1.5 years of college costs. They might be basing their college savings goals on the cost of college when they went to college, which usually is about a third lower than what the costs will be when their children enroll in college.
A better approach is to aim for about one third of future college costs, which is the same as the total cost of a college education the year the child was born.
Mistakes about How to Invest for College
When deciding how to invest college savings, it is important to consider several different consequences of each investment option:
- The impact on taxes
- The impact on eligibility for need-based financial aid
- The tradeoff between risk and return
- The combined impact on costs and return on investment, not either in isolation from the other
The most common mistakes involve a failure to consider one or more of these consequences.
- Saving in a custodial account, such as an UGMA or UTMA account, instead of a 529 college savings plan, will cost more in taxes and will yield a greater reduction in eligibility for need-based financial aid. 529 plans are tax-advantaged ways of saving for college, while custodial accounts are not. Most 529 plans are treated as though they were parent assets, yielding a lower impact on aid eligibility than custodial accounts or other child assets. Sure, a custodial account provides more flexibility if your child doesn’t go to college, but you can change the beneficiary or take a non-qualified distribution.
- Saving for college in a retirement account might allow the money to be used for retirement instead of college, but comes with stiff penalties if the money is used to pay for college. Distributions from a retirement plan may be subject to a 10 percent tax penalty in addition to ordinary income taxes. There is no tax on qualified distributions from a 529 plan. Distributions from a retirement plan, even a tax-free return of contributions from a Roth IRA, count as income on financial aid forms, reducing eligibility for need-based financial aid. Distributions from a 529 plan, if owned by the student or a dependent student’s custodial parent, do not.
- Considering only your state’s 529 college savings plan. You can invest in any state’s 529 plan. Other states might offer lower fees. You should consider any 529 plan that charges less than 1 percent in fees. Minimizing fees is the key to maximizing net returns.
- Not considering your state’s 529 college savings plan. Thirty-five states and Washington, D.C., offer state income tax deductions or credits on contributions to the state’s 529 plan.
- Choosing an advisor-sold plan instead of a direct-sold plan. Advisor-sold plans sometimes yield a better return on investment, but their fees are higher, so the net return on investment after subtracting the fees is usually lower than a low-fee direct-sold plan.
- Investment choices that are too conservative. Bank accounts and CDs have very low interest rates, compared with stock market returns. They might be safer, but the returns do not offer enough of a hedge against tuition inflation.
- Investment choices that are too aggressive. The stock market will drop by at least 10 percent at least two to three times during any 17-year period. You can control for such “corrections” by using an age-based asset allocation that starts off aggressive when the child is young and gradually shifts to a more conservative mix of investments. When the child is young, you have time to recover from mistakes and won’t have as much money at risk. When the child is older, you need to protect the college savings from big losses by locking in the gains. Two-thirds of families are invested in age-based asset allocations.
- Choosing the wrong account owner can hurt eligibility for need-based financial aid. If a 529 plan is owned by a dependent student or the dependent student’s custodial parent, it is reported as a parent asset on the Free Application for Federal Student Aid (FAFSA), with a low impact on eligibility for need-based financial aid. The FAFSA ignores distributions from a 529 plan that is listed as an asset on the FAFSA. However, if the student’s 529 plan is owned by anybody else – a grandparent, aunt, uncle, cousin, sibling or non-custodial parent – it is not reported as an asset on the FAFSA and distributions count as untaxed income to the student, yielding a severe reduction in eligibility for need-based financial aid.
- Relying on a prepaid tuition plan for peace of mind. The peace of mind associated with a prepaid tuition plan is largely fiction. Most of the prepaid tuition plans are running actuarial shortfalls and will not have enough money to cover the college costs of all participants. It is like a game of musical chairs, where you do not want to be the last person to redeem your investment. Even when a prepaid tuition plan is backed by the full faith and credit of the state, it is unclear what that really means in practice.
Mistakes about How to Use College Savings
Figuring out how to use the money in a college savings plan can be complicated. If you spend down the money as quickly as possible, the assets don’t stick around to affect aid eligibility in subsequent years. But, using too much 529 plan money in a single year can prevent you from claiming the American Opportunity Tax Credit (AOTC) and other education tax benefits.
- Using the same qualified expenses for two or more education tax benefits. The IRS has coordination restrictions that prevent double dipping. You cannot use the same qualified higher education expenses to justify both a tax-free distribution from a 529 college savings plan and the American Opportunity Tax Credit (AOTC) or Lifetime Learning Tax Credit (LLTC).
Instead, you should use cash or loans, not 529 plan funds, to pay for up to $4,000 a year in tuition and textbook expenses so you can qualify for the AOTC. The AOTC is worth more per dollar of qualified expenses than a tax-free distribution from a 529 plan, so you should aim to qualify for the maximum tax credit first and use the 529 plan money to fill in the gaps.