Money

How to save for your child's college fund

Start saving early -- and harness the power of compounding.

Sarah Tew/CNET

Americans hold a staggering $1.7 trillion in student loan debt, and though some students may have part or all of their student loan debt forgiven, many will not be so lucky. 

The average parent plans to cover about 70% of their child's college expenses -- but less than 30% are on track to do so, according to Fidelity Investments' 10th Annual College Savings Indicator. The best time to start saving for your kid's college education is right now, and perhaps the best way to do it is to just start doing it. The earlier you start, the better: Compounding interest makes a powerful tailwind. And there are some specific tools and services that can help you reach your goal faster, including 529 accounts, scholarships or a custom plan laid out by a financial adviser. The bottom line: It's never too late to start, no matter where you are in your savings journey.

How much does college cost?

Currently, the average cost of tuition and fees for four years at a public, in-state college is $42,240. For an out-of-state public program, the average cost is $108,080 for four years. If your child plans to go to a private institution, the average cost is $150,600 for four years. Room and board, which covers on-campus housing and meals, costs an additional $46,480 on average for four years at a public college and $52,480 on average for private, totaling $88,720 for a public, in-state college, $154,560 for a public, out-of-state college and $203,080 for a private institution. And, in all likelihood, those numbers will continue to ascend: Rates are expected to increase by at least 1% to 2% every year to keep in line with inflation.

How much should you save?

Though it can be challenging to come up with a specific number, especially when factoring in inflation and rising tuition costs, one approach is to use the "one-third rule." Financial aid expert Mark Kantrowitz explains: "Like any major lifecycle expense, you can spread out the cost over time, with one third coming from savings (past income), one third from current income and one third from loans (future income)." 

Coupled with the "3x rule," which dictates that the cost of a college education triples over the 17 years between birth and college enrollment, the one-third rule suggests that you should set as your goal the full cost of a four-year college education the year your child was born. You can take that number and divide it by the number of years you have left until your child starts college. That annual figure can then be broken down into a monthly goal, which is what you can use to save for a college fund. 

For example, to save for a child born in 2021 to go to a public, in-state college, a parent might determine their annual saving goal by dividing $88,720 by 17 ($5,218), and their monthly saving goal by dividing their annual goal by 12. This results in a "one-third rule" monthly saving goal of roughly $435. 

The US Department of Education offers calculators to help determine current and future costs, and there are plenty of college savings calculators to help you determine how much to save. 

How to start a college fund for your child

You have numerous options available to start a college fund for your child. Here are some of the best ways to save for college with various funding options.

529 plans

A 529 plan works much like a Roth IRA. It uses post-tax funds to save money in a tax-deferred account. When the time comes for your child to use the money, there won't be any taxes to pay as long as it's used for qualifying education expenses. You have two options with a 529 plan: a college savings plan or a prepaid tuition plan. Some states offer just the college savings plans, but others offer both. 

Besides tuition, college savings plans can be used for books, room and board, supplies and class equipment, like computers and calculators. There are charges and fees (which vary by plan and state) associated with a 529 plan, including enrollment fees, annual maintenance fees, fund expenses and administration fees. You can use a comparison tool to compare 529 plans and their associated fees in your state.

A prepaid tuition plan is available only in select states and allows parents and grandparents to lock in tuition rates for in-state public and private schools at today's costs. Some prepaid tuition plans cover tuition costs only, and you may transfer the funds to a younger sibling if your child decides not to go to college.

A 529 plan does not come without risk. You are limited with what you can do with the money, and some prepaid tuition plans don't have a guarantee if the program would fail. While you can enjoy tax benefits from funding a 529 plan, there could be penalties if your child doesn't complete their degree or uses the money for noneducational expenses.

IRAs

You could also use a Roth IRA fund to save for college for your child. Traditionally, a Roth IRA is used to fund retirement, but it can be used for other things. IRAs are not as strict as 529 plans, but you still use pretaxed money to fund the account, and distributions are tax-free. However, you should speak with a financial adviser to understand the implications of using an IRA for your child's college education, including any penalties you could face if funds aren't used appropriately. On the bright side, if your child decides they don't want to go to college, you can use those funds for your retirement.

Grants and scholarships

Another way to combat the high cost of college is with grants and scholarships. On average, your child could save about $7,310 for public college, $19,180 for a private nonprofit institution and $21,560 for a private for-profit school. Many academically or athletically inclined children receive ample opportunities for grants and scholarships, reducing how much you need to save in their college fund. Indeed, there are scholarships available for students excelling at nearly any extracurricular or hobby, no matter how niche it be. Five million scholarships make more than $24 billion available to college students each year. To get a feel for the range of aid out there, you can access multiple scholarship databases available for the perusal of parents and children looking to save on college costs. David Tabachnikov, CEO of scholarship matching and management platform ScholarshipOwl,  acknowledges that the scholarship hunt can be grueling. "Applying to scholarships can seem like a full time job -- we advise submitting applications to two to three scholarships a week, over the course of a year, to maximize your chances." 

UGMA and UTMA accounts

UGMAs and UTMAs (from the Uniform Gift to Minors Act and the Uniform Transfers to Minors Act) are custodial savings accounts, which is another way to save for college funds. The account is in the child's name, but the parent or grandparent is custodian of the account and has control until the child reaches the age of maturity in your state. There are no limits to how much money you can put into these savings accounts. The money can be used for expenses that are a direct benefit to the child, including but not limited to college expenses. The downside is that UGMAs and UTMAs are reported on the FAFSA, which can cut into your university financial aid eligibility. The account has to be distributed in full by the child's 30th birthday, and once they reach 18, the fund is theirs to do what they want with.

ESAs

A Coverdell Education Savings Account is another tax-deferred trust account option. You are limited to an annual contribution limit of $2,000, and contributions cannot be made after your child turns 18. Like UGMAs and UTMAs, all funds have to be used by age 30, but as long as they are used for education, withdrawals are tax-free. In contrast to 529K plans, ESA funds can be used for elementary and secondary education expenses as well as college, plus room and board costs. 

Trusts

Parents and grandparents can take educational trusts out to fund education expenses for a designated beneficiary. These trusts are primarily used for high-income-earning parents or grandparents as part of a tax planning strategy to limit taxable estate funds. All the money in the trust must be distributed by the beneficiary's 21st birthday. These trusts are much less commonly used, and many parents and grandparents find a 529 plan will suit their needs just as well.

Saving accounts

You can use a traditional savings account for anything, including a college fund. There are no caps or restrictions on how much you can deposit into the account. You can also withdraw money at any time. It is important to note that interest rates on savings accounts are lower than inflation, which means you won't have compounding benefiting you over the years and thus will not be maximizing your savings.

Develop a plan with a financial adviser

Over half of parents with children in 10th grade or higher wish they had saved more per month; the median saved is $200 each month. Notably, those with a financial adviser saved a total of roughly $14,000 more than parents without an adviser.

A financial adviser can be a great resource when starting your child's college fund savings. They can help you navigate the multitude of options available, including how to maximize your investments and make withdrawals the most effective when the time comes. When you work with a financial adviser, they can paint a clear path to college for your child with manageable savings goals. If you plan to apply for grants, scholarships or financial aid, a financial adviser can also help you with that process, and factor that into your college fund savings.