Saving for a child’s college education is one of the most important and daunting tasks parents face. Most parents intuitively understand that the cost of college attendance is increasing rapidly and that they need to save money regularly and aggressively in order to foot the bill. However, we have found that parents consistently underestimate the amount of savings necessary to reach the goals they have for their children’s education. We have assisted several clients with education planning recently and wanted to share some of our insights.

Many parents wisely start to think about education planning when their children are still very young. This strategy affords them more time to save and more time for their money to stay invested- increasing their potential returns. However, from a planning perspective, making assumptions about inflation rates, investment return rates, and even the number of years of education gets more difficult as the number of years before enrollment increases. That being said, the most important takeaways for new parents who wish to assist their children with education expenses are: start saving now and keep saving each month.

There are a few major issues faced by those saving for education goals:

1. A relatively short accumulation period

Most parents don’t start saving until after their first child is born and most children enroll in college around age 18. This leaves a maximum of 18 years to save for education. Compare this to retirement savings where people often have over 40 years to save toward their goals. Due to the nature of compounding returns, this relatively short accumulation period limits potential investment upside.

2. A prudent investment strategy involves getting more conservative as you approach the enrollment date

Whenever you have a defined financial goal on a specific date, the last thing you want is for your savings to be experiencing a lot of volatility close to that date. While college savings can be invested more aggressively when the child is younger, in almost all cases we recommend a more conservative asset allocation as the enrollment date gets closer. This lower level of risk also translates to a lower return potential during these years.

3. College costs have been rising faster than inflation

There are many different ways to measure the increase in the price of higher education over the years. Furthermore, the inflation rates for the price of public universities, community colleges, private universities, trade schools, and online colleges are all different. The Bureau of Labor Statistics publishes data going back to 1978 tracking college tuition and fixed fees. Their data show a 6.9% average annual increase in tuition and fees. At this rate, college costs double about every 10.5 years!

Since 1978, the S&P 500 total return has posted an 11.9% compound annual growth rate. This means the returns in the stock market outpaced the inflation rate of college costs by about 5% per year- not bad! However, remember that it’s often necessary to get significantly more conservative with your asset allocation over time- eating into your return potential. With bond yields as low as they currently are, it’s entirely possible that a conservative portfolio doesn’t even keep pace with the inflation rate of college costs.

Each of the aforementioned factors shows the need to start saving for education early. You want to not only give yourself more time to save, but also give yourself more time to utilize a more aggressive asset allocation and (hopefully) outpace the rate of tuition increases. However, the bottom line is regardless of how early you start saving, a college education is expensive and the costs have been rising. The table below shows what the total costs will be in 18 years for four years of school under various inflation rates and for different types of colleges.

We mentioned that the historical inflation rate for college tuition and fees has been about 6.9%, but it’s important to also consider the more recent trends. As you can see in the chart below, the rate of year over year inflation has fallen dramatically since hitting a peak of 9.5% in 2004. Over the last 10 years (2009 to 2019) the average rate of YOY inflation has been about 3.8%.

So how much do you really need to be saving each month to meet these goals? As with all questions relating to financial planning, it depends. The one constant we observe is that people significantly underestimate the amount of savings needed. Below are a few tables showing how much you’ll need to save under a variety of scenarios.

The chart below shows the required level of savings under a range of expected average returns and the expected average annual cost increases. The assumptions are as follows- savings start at the birth of the child and continue until the child completes college, four years of in-state college attendance at the current average cost ($21,950) including room and board, and using a 529 plan for all savings. Keep in mind that attending a private school or out-of-state public school or failing to graduate within four years will substantially increase the necessary level of monthly savings.

As you can see, the amount of required savings is large, even under using more favorable assumptions. Let’s take the example of an 8% rate of return and a 3% inflation rate. This would require parents to save $264 per month for 22 years or a total of almost $70,000! Using slightly more conservative numbers like a 7% expected return and a 5% inflation rate results in a total of about $113,000 that must be saved.

In the vast majority of cases, we do not recommend clients place all their college savings in 529 accounts. The biggest reason for this is the rigidity of the tax rules for 529s. 529 plans are similar in tax treatment to Roth IRAs- contributions are not tax deductible, income and capital gains are not taxed as they accrue, and withdrawals for qualified education expenses are tax-free. Issues arise, however, when more money is contributed than is needed- like when the child receives a large scholarship or doesn’t attend college. If withdrawals are non-qualified, ordinary income tax plus a 10% penalty is due on withdrawals in excess of the cost basis. The beneficiary on a 529 can also be changed to another family member which is often the route parents choose to take. Finally, when contributions are made to a 529, they are, in a sense, “locked-up.” Contrast this with savings in a taxable investment account where parents can make withdrawals whenever they want- without penalty and without restrictions on its use. For these reasons and others, we most commonly recommend parents save for college using a combination of a 529 plan and a taxable account. However, the relative tax disadvantage of taxable accounts increases the necessary level of savings. That being said- taxable accounts can be used for college savings before the child is born- dramatically increasing the amount of time for those parents who really plan ahead.

For parents who are ready to start saving, it’s important to be realistic about what your savings goals are and what your ability is to save. As you have seen, the required level of savings to cover the entire cost of attendance is very high and may not be realistic for many parents. Here are some questions to think about:

• What portion of my child’s education would I like to cover?
• How large a portion should my child cover?
• Where is my child likely to attend college- public vs. private, Northeast vs. Southern, small vs. large?
• Are there other family members who are likely to assist with tuition?

These are just a few of the things that need to be considered prior to formulating a savings plan. We strongly recommend working with a CERTIFIED FINANCIAL PLANNER™ who can help you determine the amount of savings necessary and recommend the best course of action for you.