Although parents believe that education is an investment in their child’s future, only 57% are saving for college. In addition, these families had saved an average of just $16,380 for college by 2016.1
Solution: Get started saving early
The first step is to have a plan, which helps families stay on track with college savings. It’s best to start saving when your child is an infant. Strategies include automatically depositing funds into a savings account each pay period and committing a certain percentage of tax refunds or bonus money to college savings. In addition, parents should review their college-savings goals annually and make adjustments, if necessary.
While financial aid from scholarships, grants and loans can contribute to paying for college, it doesn’t typically cover the full cost. The U.S. Department of Education uses the financial information students provide on their Free Application for Federal Student Aid (FAFSA) to calculate an Expected Family Contribution (EFC) that determines eligibility for federal student aid.
Under the EFC formula, a parent’s contribution to pay for one year of college typically factors in 22-47% of annual income.2 This fact highlights the need for families to save now for their child’s college education — even if parents plan to start small and regularly increase their contributions over time.
Many families have historically employed Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts for college savings. However, an UGMA/UTMA-based approach doesn’t offer tax-free growth.
Solution: Invest in 529 college savings plans
Created in 1996 by Congress, 529 college savings plans are specifically designed as a tax-advantaged way to save for higher education expenses. However, there continue to be misunderstandings about these accounts, which may prevent some investors from taking full advantage of the tax benefits. Only 37% of families currently use 529 plans for college savings.1
In addition to tax benefits for contributions and on withdrawals for qualified higher education expenses — such as tuition, room and board as well as required books and supplies — 529 plans allow earnings on investments to accumulate tax-free. For example, if the parents of a newborn invest $100 a month in a 529 plan and earn an 8% average annual return, the account could grow over 18 years to more than $48,000 by the time their child is a college freshman.
However, the same hypothetical investment in a taxable account would have incurred $9,400 in taxes. Based on the 2014-15 academic year, that amount would have been nearly enough to pay for a full year of the average cost of attending most public universities net of scholarships and grants of $13,200.3
UGMA/UTMA accounts are also generally not treated as favorably as 529 plans when calculating a student’s EFC. A 529 plan account is typically considered an asset of the parents and factored into the EFC at a rate of 5.6% of the amount invested. UGMA/UTMA accounts are considered to be student assets and are usually factored in at the rate of 20%.2
The tax benefits associated with contributions to the 529 plan that your state offers are an important consideration. However, other factors may be equally important.
Solution: Compare out-of-state 529 plans
An out-of-state 529 plan with a track record of superior results and low expenses may be more attractive in the long run than your state’s tax benefits.
In addition, an actively managed 529 plan that is more growth-oriented initially and becomes more conservative as college enrollment approaches may be a good fit. Morningstar offers an objective analysis of 529 plans.
Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses, summary prospectuses and CollegeAmerica Program Description, which can be obtained from a financial professional and should be read carefully before investing. CollegeAmerica is distributed by American Funds Distributors, Inc. and sold through unaffiliated intermediaries.
Depending on your state of residence, there may be an in-state plan that offers tax and other benefits not available through CollegeAmerica. Before investing in any state's 529 plan, investors should consult a tax advisor.
If withdrawals from 529 plans are used for purposes other than higher education, the earnings will be subject to a 10% federal tax penalty in addition to federal and, if applicable, state income tax.