Efficient College Savings: Cut Your Costs by 57%
In recent years, inflation has taken an unexpected turn after decades of relative stability. From 1992 to 2020, the Consumer Price Index (CPI) in the United States remained between -0.4% and +3.8%. However, in 2021 and 2022, CPI surged to +4.7% and +8%, respectively. While concerns about rising inflation have become widespread, there's a particular area where high inflation has been prevalent for years – college education.
According to the National Center for Education Statistics, the average inflation rate for public 4-year colleges from 2000 to 2020 was a staggering 5.1%. Today, the national average total cost for a public, four-year, in-state, on-campus college education hovers around $28,000 per year. If we assume that education costs will continue to rise at a 5% rate, parents of a child born this year will need an estimated $275,000 to cover the total cost of 4 years of college.
To accumulate the $275,000 college fund mentioned above, investing in a conventional brokerage account would require an annual investment of about $7,600 per year over 18 years, totaling $136,800, assuming a 9% rate of investment growth and factoring in a 33% tax on investment returns (comprising a 20% long-term federal capital gains rate and a 13% California state rate).
For those with the means, making a lump-sum investment at the start of a child's life may present a better option, with an initial investment of approximately $79,000. The lower cost here is attributed to the compounding power of interest over time.
Enter the 529 plan
529 plans enable families to invest in private K-12 schooling or higher education without incurring capital gains and other investment taxes, resulting in substantial savings over a 10-20 year period. Consider the following:
Using the same assumptions as before, parents would need to save only about $6,100 per year in a 529 account over 18 years to cover college costs, totaling $109,800. By utilizing the 529 account, we've reduced the out-of-pocket cost of college by 20%! For those who can afford it, a lump-sum investment in a 529 plan at the start of a child's life would require only $58,500, a 26% reduction compared to investing a lump sum in a regular brokerage account.
This serves as an excellent illustration of how proactive planning can lead to significant cost savings. The difference in cash outlay between the least efficient savings method (annual saving in a taxable brokerage account) and the most efficient one (lump sum in a 529) is an impressive $78,000. Put differently, opting for a lump-sum investment in a 529 plan, as opposed to saving over 18 years in a regular brokerage account, reduces the out-of-pocket cost of college by a whopping 57%, based on these assumptions.
It's clear that investing earlier rather than later is the preferred approach if you have the means. Contributions to a 529 plan are limited to the gift tax exemption threshold, which is currently $17,000 per year per giver (or twice that for a couple). Gifts exceeding this amount must be reported to the IRS by the giver and count against the giver's lifetime gift and estate tax exclusion, which is presently $12.9 million per person. With a combined exemption of nearly $26 million currently, very few families need to worry about surpassing the $17,000 per-person limit, as long as they file form 709.
However, if you have the means and want to give your child's 529 plan a head start, you can do so while still preserving your lifetime exemption by taking advantage of the superfunding rules. As of 2023, this allows each parent or grandparent to contribute $85,000 ($170,000 per couple) into each child's 529 plan as soon as they are born. Grandparents can also make contributions alongside parents in the same year. So, if you plan to send your children or grandchildren to college and have the financial flexibility, there's no reason not to contribute early and generously.
For those who are starting their college savings journey late, don't lose hope. While you can't change the past to take advantage of missed tax savings, you can adopt smart investing and tax strategies going forward.
If you've overlooked the benefits of a 529 plan due to lack of knowledge, consider what other tax-saving opportunities you might be missing for your retirement savings and other aspects of your financial life simply because you're not aware of them. This highlights how a qualified, fiduciary financial advisor can provide significant value to you.
If you'd like a free analysis of your college education savings plan or access to our college education savings calculator, please reach out to us. We're here to help you make informed financial decisions for your future.
This article is for illustrative purposes only. No part of this article should be construed as a recommendation to buy or sell securities, or as personal financial or tax advice. Please consult your financial planner and/or tax professional before implementing any financial or tax strategy.