When our kids are young, it’s easy to get wrapped up in the day-to-day. Parenting is hard, and it’s tough to look much farther ahead than next Friday when you’re in the weeds with middle school math homework, preschool drop off, and Minecraft server dramas. Still, sometimes taking a step back and planning for your children’s future is a necessary part of parenthood. Although it doesn’t feel like it right now, you’ll be watching them graduate high school in the blink of an eye, and you want them to be financially prepared for their next steps.
Knowing where and how to start saving can be stressful. The good news is that, it’s not so hard to know the basics: 529 plans have lots of benefits, and the earlier you start, the better.
What is a 529 Plan?
If you’re trying to save for future college expenses, it’s tough to beat the tax benefits of a 529 plan. Traditionally, these are the accounts that most parents choose to start building a college “nest egg” for their kids. The first 529 plan was founded in 1986 by the Michigan Education Trust (MET), and now they’re a nationwide phenomenon. Essentially, this account is an investment vehicle that’s specifically geared toward saving for college and other education-related expenses.
Any withdrawals (including earnings) from a 529 plan can be accessed tax-free as long as they’re going directly toward a qualifying education-related expense. This is a huge benefit to parents, and one of the best tax-advantages available in different investing and savings accounts. Of course, it’s important to remember that if you don’t use the funds from your 529 plan for qualifying expenses, you’re going to get saddled with a hefty 10% penalty on the withdrawal and you’ll have to pay taxes on the earnings from the account.
What Can a 529 Plan Be Used For?
Right now, funds from a 529 plan can be used for qualifying education expenses at a K-12 or college level. However, this hasn’t always been the case. In the past, 529 plans only covered post-K-12 education expenses. However, in the 2018 tax year, you’re now able to withdraw $10,000 per student, per year, for elementary or secondary education expenses. While this new tax law made funding private education at a K-12 level much easier for some families, it also complicated what was considered a “qualifying” education expense.
Let’s talk about what expenses your 529 plan does cover:
- Tuition expenses for K-12 (private school) or college education
- Room and board
- Tech and equipment (at the college level)
- School supplies (at the college level)
- Books (at the college level)
What Doesn’t Qualify?
Too often, people use funds from their 529 plan to cover education-related expenses that don’t qualify – and are unpleasantly surprised when they’re hit with the 10% penalty and taxed on their earnings. Knowing what you can’t spend your 529 plan funds on is incredibly important:
- Transportation to and from a K-12 school or university
- Expenses of student loans
- Gym memberships through a university
- Expenses associated with school-sponsored clubs or events
Saving for Your Child’s Education (and the Benefits of Compound Interest)
As is the case with all things savings-related, the sooner you get started saving for your children’s education, the longer you’ll be able to take advantage of compound interest to grow your contributions. Compound interest is often compared to rolling a snowball down a hill. When you’re standing at the top of the hill, scooping up a handful of snow and pressing it into a snowball, it seems pretty small.
But when you roll the snowball down the hill, it picks up more and more snow with each revolution. The more surface area on the ever-growing snowball, the more snow it’s able to pick up. Obviously, if the hill is a big hill (or you’re contributing funds for a long time), the “snowball” has more time to grow.
Likewise, if you start saving for your child’s education expenses early, your money has more time to take advantage of compound interest. Even small contributions made sooner rather than later have a big impact.
Setting Education Savings Goals
Factoring education savings into your budget can be a challenge. Raising kids can be expensive enough as it is without thinking about a bigger, more intimidating cost like college tuition. That’s why viewing education savings as part of your comprehensive financial strategy, and prioritizing multiple goals can help. For example, it can be useful to view your savings goals as a kind of hierarchy:
- Emergency savings
- Retirement savings (+10% or max it out)
- Saving in an HSA/FSA account
- Regular college savings (ok to start small, but start as soon as you can!)
- Saving toward “big picture” goals like home ownership, buying a new car, etc.
Within that budgeting hierarchy, you also have to fit day-to-day expenses and debt repayment. We understand there might not be enough money to max out contributions in every single category. Instead, you may need to pick and choose or continually contribute smaller amounts to some of your lower-priority savings goals (like your children’s 529 plans, or toward “big picture” purchases you’re working toward).
When your kids are younger, you can’t have a candid conversation with them about a college budget, or what type of school they want to attend. However, as they get older, these conversations can help set expectations about money available for college, ultimately influencing your child’s college decision (and motivation to apply for scholarships and grants!)
You can also look into what your expected family contribution (EFC) might be, and what kind of aid you’ll be able to expect as you get closer to the time when they’ll be enrolling. (I predict you will be disappointed).
As much as you might want to provide a completely loan-free college experience for your kids, that may not be a realistic expectation, especially if they already have their heart set on an expensive school. Instead, focus on how you can minimize the impact of loans on their education, focus on accessing scholarships and other types of aid, and set a savings goal for yourself that doesn’t sacrifice building your emergency fund or saving toward your longterm goals (like retirement).