When should you start saving for your child's education?

You can help your child pay for college by saving (and saving early!), but before you open any accounts, be sure your understand your situation, and your options.

Brian Snyder/Reuters/File
The silhouette of a student with a graduation cap as students take their seats for the diploma ceremony at the John F. Kennedy School of Government during the 361st Commencement Exercises at Harvard University in Cambridge, Massachusetts (May 24, 2012).

College is expensive, and it's only going to get more expensive. Tuition costs continue to climb at a rate significantly higher than the inflation rate. In fact, on average, the cost of college doubles about every nine years. This means that for a child born today, once they enter college, the college costs will be nearly four times what they are now. You can help your child pay for college by saving (and saving early!), but before you open any accounts, be sure your understand your situation, and your options.

Is It Better to Save for Your Retirement or Their Education?

In a perfect world, you should be saving both for your retirement and your child's education. It's also important to have a sizable savings account in case of an emergency. However, if you can't save for everything, the first priority is to save for your own future retirement.

If your child doesn't have enough money for their education, they can always take out educational loans and apply for scholarships. You won't be able to take out loans for your retirement, so it's important that you save for retirement first.

If you can afford to save for your child's education, here's what to expect.

Compound Interest Is Your Friend

The best time to start planning for your child's education is from the day they are born. If you begin saving from day one, a good estimate is to save $250 a month for an in-state public college, $400 a month for an out-of-state public college, and $500 a month for a private college.

As is the case when saving early for retirement, saving early for your child's education can be huge. Compound interest can be your best friend because the interest that you earn early on will also earn interest from then on, which can spell huge gains if you start investing early. On the other hand, the longer you wait to save, the less interest you will accumulate, and the more you will need to save later on.

For instance, if you start saving $250 per month at a 6% return from the time your child is born, you'll earn approximately $97,330 by the time they enter college. If you wait until they are 10 years old to begin saving, you'll have approximately $30,862 accumulated by the time they enter college. This is the beauty of compound interest.

How to Invest

In most cases, if you start saving early, it is best to use an age-based allocation for your investment. This means that it will start with more aggressive investments to earn more interest early on. The allocation will then become more conservative as your child gets older and closer to entering college.

529 Savings Plans

A 529 college savings plan, also known as a Qualified Tuition Program, will allow you to save for your child's education in a tax-free manner. Each 529 plan has its own associated annual fees and operating costs, so you will want to carefully compare these to get the best deal.

The plan works similarly to a 401K or IRA, so the contributions will be taxed, but the earnings will not be. You can contribute to this tax-free account until your child is 18. The money from the account must be used by the time they are 30. If your child decides that they don't want to go to college, you can change the beneficiary.

Coverdell ESA

A Coverdell Education Savings Account is a custodial account that can be used to cover any educational expenses, at any time, so you won't need to wait until your child enters college. While they function similarly to a 529 savings plan, the contribution amounts are much lower. While a 529 account allows lifetime contributions of $200,000–$400,000, a Coverdell ESA only allows contributions of $2,000 per year. The money from the account must be used by the time they are 30.

Prepaid Tuition Plans

A prepaid tuition plan will allow you to purchase tuition credit in advance at a predetermined price from an in-state public school, though many will also cover out-of-state schools. This means that you can pre-purchase tuition at today's price, so you won't need to worry about inflation or the increasing cost of education. These plans have the same tax and financial aid restrictions as 529 savings plans. The major downside to the plan is that if your child decides to go to another school, you'll get a return of your money, but inflation can still affect you.

For instance, say you invest $10,000 for a year of tuition and the cost per-year increases to $20,000. You would still get a full year's worth of tuition. If your child decides to go to another school, your original investment of $10,000 (plus a very small amount of interest) will be returned to you. However, now that the tuition per year is higher, your investment won't go as far.

UGMA and UTMA Accounts

UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) accounts are custodial accounts, which will allow you to reserve cash and assets for your children. According to the IRS, the initial $1,000 in gains is tax-free, the next $1,000 is taxed at the child's income tax rate, and the remainder is taxed at the parent's income tax rate. The downside to these accounts is you have less control over how your child spends the money because there are no restrictions on how the funds are used as long as they directly benefit your child. Once your child comes of age (between age 18–21, depending on the state), they can use the money however they choose.

Using Your IRA to Pay for Your Child's Education

The IRS allows you to withdraw IRA funds tax-free and penalty-free to pay for qualifying educational expenses. This will allow you to save for their education, while having the peace of mind that if your child decides not to go to college, you can still use the funds for retirement.

Avoid the Savings Account Trap

Opening a savings account in your child's name may seem like a good idea, but it may end up costing you in the end. Financial aid is based on assets from the year prior to applying for aid. When determining how much financial aid to award your child, they will consider your child's savings accounts as well as any funds in any custodial accounts. This means that if your child has a large amount of savings in their name, they may end up losing out on financial aid.

Getting a Late Start

If you haven't begun saving for your child's education as they approach college, it's never too late to start. If you have less than five years to save before they enter college, it may be a good idea to work with a financial planner or advisor so that they can help you get the most from this time. They can help you determine what your risk tolerance is so that you don't invest too aggressively and take on too much risk in an effort to catch-up.

Get Your Child to Help

Once your teenager lands their first job, be sure to to make it into a learning opportunity for them. This can be a good time for them to begin saving and breaking their paychecks up into three portions: weekly expenses, short-term goals, and long-term expenses (such as saving for college). This will help to relieve some of the burden, and it will prepare your child for the real world and teach the importance of saving.

This article is from Andrea Cannon of Wise Bread, an award-winning personal finance and credit card comparison website. This article first appeared in Wise Bread.

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