The first thing you should do is find out how much college will likely cost for your child when they will be attending. Use this number as a worst-case scenario because it is likely that your child will be able to receive some small scholarships or other forms of financial aid.
Start Saving Early
How much money you are saving is less important than how soon you begin saving. Compound interest is a wonderful thing and the longer your money has to grow, the more it will grow.
When you begin saving and investing early on that money goes to work for you so that you don’t have to save as much. Take a look at these examples to illustrate the power of compounding over time:
- Begin investing $5,000 each year when your child is 10 in an account that earns 11% annually. This would result in a total savings of over $65,000 by the time they are 18. Total money invested: $40,000.
- Begin investing $2,000 each year when your child is 8 in an account that earns 11% annually. This would result in a total savings of over $37,000 by the time they are 18. Total money invested: $20,000.
- Begin investing $3,000 each year when your child is born in an account that earns 11% annually. This would result in a total savings of over $148,000 by the time they are 18. Total money invested: $51,000.
- As you can see, if you begin investing as soon as possible you could save less money annually and only $11,000 more in total than if you waited 10 years and end up with $83,000 more!
In these examples we used an annual return of 11% which comes from the average annual return of the broad stock market.
Some years will return more while others will return less. These numbers are for illustration purposes and do not take into account additional tax savings or credits that can be obtained when using tax-favored college savings accounts.
College Savings Plans
There are several college savings plans that are important to know about.
Two of the plans that are most frequently used are the Coverdell ESA and the 529 plan.
Total contributions to the Coverdell ESA per beneficiary cannot be more than $2000 per year, and there are income limitations with this type of college savings plan. Your modified adjusted gross income must be less than $110,000, or in the case of a joint return, less than $220,000.
A 529 plan differs in that there are much higher contribution limits which are usually left up to the state. Additionally, there are no income limitations associated with a 529 plan.