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Seeing the price of college education today can cause sticker shock for a lot of parents, and rightfully so — if you're willing to spend money on attending a four-year public college, it will cost $10,560 on average per year, according to the College Board. The sticker price of one year at a four-year private college will cost you a whopping $37,650 on average. Though the average cost of attending college is less than the sticker price because of college scholarships and grant aid, paying for higher education is still no small feat.
It can be hard to know where to start, especially when you have more immediate financial priorities like paying for childcare and rent. However, having a plan and investing early is crucial in making sure that you or your child won't be forced to take out student loans and then be on the hook for paying off that debt down the line.
Select spoke to higher education expert and author of How to Appeal for More College Financial Aid Mark Kantrowitz about how much money parents should aim to invest for their child's education, when they should start and where they should put their money.
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The most important part of saving for college is investing as early as possible. Since compound interest is interest earned on both the initial investment and the interest you've accumulated, your gains will be much larger if you start investing at birth.
You can think about it like this: With compound interest, an initial investment of $1,000 will yield earnings of $100 after one year if there's a 10% interest rate that's compounded annually. Your second year, you'll earn an additional $110 because you'll be receiving 10% interest on the $1,100 you've accumulated.
Kantrowitz recommends the one-third rule as a rough guide for how much parents should be saving: one-third of the cost of a four-year college education will come from parent's income and financial aid, one-third from savings and investments and one-third from student loans. Once you decide what percentage of your child's college education you're willing to fund, you'll have to figure out how much that will cost you each month.
According to Kantrowitz, about one-third of your college savings will come from your investments if you start investing at birth. However, if you start investing when your child is in high school, only one-tenth of your college savings will come from your investments. In other words, your college savings will be nearly three times bigger if you started investing at birth than if you started in high school.
The cost of college rises by roughly a factor of three every 17 years, so if your child is a baby now, you should aim to invest the current cost of a four-year college education over the span of the next 18 years.
For example, if you want your child to attend a four-year in-state public college, the current cost of attendance (this includes tuition, fees and room and board) for one year is $26,820, according to the College Board. You'll have to invest roughly $300 every month starting at birth to send your child to a four-year in-state public college (assuming a 3% inflation rate), according to Kantrowitz. For a private non-profit college, you'll have to invest $600 a month.
If your investments yield a 6% rate of return each year, you'll earn roughly enough money to cover 1/3 of your child's total college costs once they're 18.
While this may seem like a lot, investing any amount of money each month is a good idea. Set up automatic transfers to your investment account so you don't have the temptation to spend the money once it's in your checking account. And if you can't put a lot away right now, over time, you can ramp up your monthly contributions — it's essential to start investing early to take advantage of compound interest.
If you're investing for college you should consider opening a 529 savings plan or a state-sponsored investment account exclusively used for investing for school. With 529 savings plans, individuals can use the money they withdraw for college and K-12 tuition and other qualified educational expenses without paying income tax on any investment gains.
529 savings plans contain a variety of different funds such as mutual funds, bonds funds and ETFs. They are generally recommended for investing for college because of the tax benefits people get from them: You can contribute up to $15,000 tax-free (for single tax-filers) and your earnings will grow tax-free.
States offer different 529 savings plans, and you don't need to be a resident of that state in order to qualify for an account. However, certain states may offer tax benefits for in-state contributions. For example, in New York, in-state residents have tax-deductible contributions, so residents can reduce the amount of their taxable income if they invest in a 529 savings plan.
You can also opt to invest for your child's education using a brokerage account or a 529 prepaid tuition plan. These, however, are less popular options.
If you opt for a 529 prepaid tuition plan, you pay for tuition at certain colleges at today's rate. By doing so, you're hedging against inflation and rising tuition costs. While you can transfer your funds if your child chooses to attend a different college, prepaid tuition plans have their drawbacks: there are only 18 state-sponsored plans that offer this, you have to be an in-state resident and they don't cover additional educational expenses like 529 savings plans do.
You might also consider investing your money in a brokerage account through companies like TD Ameritrade, E*TRADE or Vanguard. If you go this route, however, you'll forgo some of the tax benefits that you'd get if you invested in a 529 savings plan. Namely, you'll have to pay tax when you sell any of your funds or stocks that have grown in value.
There's no denying that the cost of college is rising rapidly — even the thought of paying it can be daunting for many parents. However, parents should start saving as early as they can so they can reap more profits from their investments.
Once parents determine what percentage of their child's college education they're willing to pay for, they can create a plan for their monthly contributions. They'll have the option of investing in a 529 savings plan, a brokerage account or a prepaid tuition plan, but they'll likely get the most tax benefits and flexibility from a 529 savings plan.