How to Save for Your Kid’s College
According to the College Board, the average cost of tuition and fees for 2016-2017 school year was $33,480 for a private school, $9,650 for an in-state public college, and $24,930 for an out-of-state public university.
That's just for tuition! Books, housing, meals and travel are all additional.
As if that wasn't scary enough, the College Board also projects those numbers to rise at about 5% a year. Long story short, sending your kids to college will not be cheap. So, you better start saving now.
Today, we want to help you figure out how to save for your kid's college by comparing the traditional 529 plan to our turn-key rental property plan.
529 Savings Plan
Created in 1996 as a tax-advantaged way for parents to grow their children's college savings, most 529 savings plans work a lot like a Roth IRA. You make after tax contributions and typically select from a series of mutual funds.
The main advantage of a 529 plan is its tax benefits. While your contributions aren't tax deductible, your gains grow tax-free. Withdrawals, as long as they go towards approved educational institutions, will be tax-free as well. These 2 benefits make the 529 plan superior to a traditional brokerage account for education expenses.
Turn-Key Rental Investment
Many people mistakenly forget to consider rental property investments when they consider saving for college. As we've documented [ks1], the ability to leverage smaller sums of money into bigger returns over time is tremendously powerful.
In most cases, turn key real estate investments can even outperform their tax-advantaged 529 counterparts.
Here's the Math
Disclaimer: Several variables go into any investment projection. The estimates we've used reflect long-term market conditions and returns. You can find more information on some of the terminology used here[KS2] , as well as a more thorough breakdown of rental property expenses here[KS3] .
For the sake of this comparison, we assume you want to begin investing for college as soon as your child is born. (Note: 529 plans do not require you to have children at the time the account is opened). We also assume, you want to accumulate enough for them to at least be able to attend any public school when the time comes. Based on the College Board projections, this means you will need approximately $260,000 to cover 4 years of tuition.
The 529 Savings Plan
As we've noted before, the average long-term market return is 6-7% after fees, etc. Most 529 plans have slightly higher fees and fewer options than traditional brokerage accounts. Based on this, we've used an average growth rate of 6% in our calculations. Keep in mind that as high school graduation approaches, you will want to move to a more conservative mix to ensure the money isn't wiped out in a market correction.
Here are 3 ways to achieve your $260,000 goal with a 529 plan.
- Monthly Contributions – By contributing $660 per month over the next 18 years, you can fully-fund your child's tuition. In total, your contribution will be a little over $142,000 and the market will provide the rest. If you can handle the monthly payment, this is not too bad.
- Rich Grandparents – Anyone can contribute up to $14,000 per year to each child's plan. After that, certain gift taxes apply. So, if both parents and all 4 grandparents each contribute the maximum, you can immediately stash away $84,000. Even this massive investment won't quite get you where you need to be though. Someone, will have to cough up another $7500 in year 2. For those of you who can actually pull this off, you reduce the cash requirement to $91,500 and rely on the market for $168,500 of growth.
- Less Rich Grandparents – However you get there, annual contributions of $20,500 for the first 5 years will also achieve the goal.
Ok, now let's say you purchase a rental property for $120,000 with a 20% down payment and 3% in closing costs. Your initial investment here is slightly more than Option 3 above at $27,500.
By purchasing a good property in a good neighborhood, you will achieve both income growth and appreciation. Because the goal is for education, we assume you will invest the excess income each year to pay down your mortgage.
Assuming initial rents of $1100 per month and accounting for all expenses (PITI, management, vacancy, maintenance, cap-ex),the combined after-tax value of the home plus excess income is around $263,000. This one home can therefore fund all 4 years of tuition and your total investment was a fraction of the 529 scenarios.
Because this is a turn-key investment there is no additional work on your part beyond what it takes to maintain a brokerage account. So, for the same effort and significantly less money, you can provide a fantastic start to 'the real world' for your child.
It's impossible to predict your child's future. Perhaps he or she will be an academic or athletic superstar and earn significant scholarships. On the other hand, college (especially out-of-state) isn't for everyone. There are plenty of scenarios where less expensive education will be the right decision.
In these cases, the 529 plan loses even more luster. If the withdrawals are not made for educational purposes, the tax-advantages are lost and you simply have an underperforming brokerage account. Real estate holdings are unaffected in this scenario.
When considering how to save for your kid's college, it is important to consider all of your options. Traditional 529 plans have benefits, but also come with certain drawbacks. Real estate investments may require less of your own money and provide greater flexibility in the future. You owe it to yourself and to your children to make sure you understand the choices.