Amid the pressures of inflation, the average cost of higher education is continually rising. While varying by state and public or private institution, the average college tuition costs more than $24,000 per year, and can easily top six figures over four years, especially when other expenses are included.
This financial climate can make saving for college especially important. But planning for the costs of tuition, room and board, and other expenses associated with post-secondary education is no easy feat. With so many choices to make about savings vehicles and investment strategies, mistakes can happen that have both financial and tax implications.
How to avoid 5 common mistakes when saving for college
When it comes to saving for college, starting early is one way to increase the odds of having enough money to pay for the costs of higher education. Still, there are considerations for families to weigh including awareness of common—and sometimes costly—mistakes. The following 5 questions can help a saver avoid potential pitfalls.
1. Are you saving enough?
Many families won’t be able to afford the full costs of their child attending college. A 2021 report by student loan lender Sallie Mae found that family income and savings only covered about 53% of higher education costs. The rest came from scholarships and borrowing.
Saving early, often, and in larger amounts can help families maximize the impact of their savings. That’s because time allows for compounding interest (for potentially greater returns) on the investments that make up these savings vehicles. For example, if a family invests $1,000 with $100 in additional annual contributions and an estimated 10% rate of return, they can expect to have roughly $4,200 a decade later. Larger investments and more frequent contributions could grow even more. Take the same contribution amounts over a 20 year period and the family would have more than $12,000 saved.
2. Is a 529 plan the right choice?
A 529 plan is a tax-advantaged investment plan designed to encourage people to save for college expenses. Savers’ contributions can grow tax-free, as long as the funds are used for qualified higher education expenses when withdrawn.
The government views 529 plans as assets belonging to the parents. That means if (and when) the child applies for federal student aid, the money in these accounts doesn’t significantly impact financial aid—a maximum 5.64% of its assets are considered in the family income calculations.
There are two types of 529 plans to consider: Prepaid tuition plans and education savings plans. A prepaid tuition plan, which allows money to be paid in advance all at once or over a period of time, applies to tuition and fees. An education savings plan covers other qualified education expenses such as room and board, and books, for example. The two are not equal.
With the prepaid tuition option, room and board is not considered an eligible education expense. This type of plan aims to lock in the tuition costs early, but there are potential risks: Some states guarantee the money paid into the prepaid tuition plans they sponsor; some do not. Additionally, withdrawing funds for nonqualified expenses could incur penalties of as much as 10%. The IRS’s list of qualified education expenses for 529 plans has the complete list of exemptions.
Each state has its own rules surrounding 529 plans. Many states set their own contribution deadlines, list of eligible colleges and universities, and total contribution limits. A financial advisor can help in understanding the tax implications and advantages from year-to-year.
With a college savings plan, the money invested is not guaranteed to grow. So if a plan’s sponsor has a financial deficit, there is the possibility of losing some—or all—of the money in the plan. Also, there’s no promised return on investment, and like the stock market, investments can decrease over time depending on market conditions. There may also be underlying management fees and expenses.
3. Are you adjusting your asset allocation over time?
Regardless of which savings plan you choose, there’s the task of selecting an asset allocation, or the mix of cash and securities like stocks and bonds, that are part of a diversified portfolio. Savers with longer time horizons—think: parents of young children with 10 or more years to save—may opt for a riskier mix of assets in the beginning and adjust to become more conservative over time, as the child nears college age.
529 plans have an option for age-based asset allocation where rebalancing is done automatically. With these plans, there are typically three risk levels: conservative, moderate, and aggressive—with a higher percentage of stocks during a child’s younger years; the account automatically reallocates assets to a more conservative mix as the beneficiary grows older. Or, investors may choose a static allocation, if they want to select assets manually.
Investors who choose a static allocation, or who choose a non-529 plan that they manage themselves, are responsible for adjusting their asset allocation. These investors may ask themselves: Is my asset allocation appropriately risky or conservative, given how close my child is to going to college?
4. Did you remember to consider the American Opportunity tax credit?
The American Opportunity tax credit (AOTC), previously known as the “Hope Credit,” is a tax-deferred credit for qualified education expenses.
The AOTC allows the deduction of a student’s qualified education expenses (including tuition and textbooks) for the first four years of college, with a maximum annual credit of $2,500 per eligible student. According to the IRS, if the credit brings your tax liability to zero, then money can be refunded—40% of the remaining credit, but no more than $1,000. There are also limits on how much taxpayers can earn each year to claim the credit. Only single filers with a modified adjusted gross income of $80,000 or less, or married couples filing jointly with income of $160,000 or less, can qualify, with the credit phasing out as income increases.
Requirements of the AOTC, according to the IRS, include:
- Pursuit of a degree. The student must be pursuing a degree or “recognized education credential” from a higher education institution.
- Enrollment. At the start of the tax year, the student must be enrolled at least half-time for at least one academic period.
- Undergraduate status at beginning of tax year. The student must not have completed four years of college at the beginning of the tax year.
- Limits on length of credit use. The student (or say, a parent on behalf of the student) cannot have already claimed the AOTC for four tax years.
- Absence of felony drug convictions. The student cannot have a felony drug conviction on his or her record at the end of the tax year.
Checking eligibility requirements for this credit takes careful consideration, because if an error is made in claiming the credit, the amount of the AOTC must be paid back with interest.
5. Are you taking IRA distributions for the wrong things?
Using money from an IRA means you will be borrowing money from your future living costs to pay for current expenses. For that reason, IRAs come with strict rules and penalties if account holders dip into them early. However, there are a few exceptions, such as college-related tuition and expenses.
What are some factors to consider before withdrawing from your IRA?
- Timeline for use of funds. Use of the money in this type of savings account needs to be used in the same year that qualified college expenses are due.
- Limits on the amount of funds taken out. Withdrawals cannot exceed the total cost of education expenses. A 10% penalty may apply for higher withdrawals.
- Cannot regain interest on withdrawals. IRA withdrawals— unlike 401(k)s—cannot be paid back. So, account holders do not have the benefit of paying back the funds and accruing the compounding interest that they would otherwise have earned.
The bottom line
With the right tools, families and students can navigate their way through four years of academia with a solid financial foundation. Key is knowing how much to save, the tax advantages—and potential pitfalls—to a 529 plan, as well as awareness of additional ways to secure funds for college, such as IRAs. By understanding common mistakes when saving for college, families can be in a better position to reach their targeted savings goals for college.