One of the most stressful tasks that parents face is saving money for college for their children. With the cost of higher education continually increasing, parents can quickly feel overwhelmed by the numbers. To make matters even worse, a number of different savings options exist, and choosing the best one can prove difficult.
While it is important to have a clear grasp of the various options and their advantages and disadvantages, it is just as important for parents to know the common missteps that can be made while saving for college. Below is a look at some of the mistakes that parents make most often and some tips on how to avoid falling into the same traps.
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Not saving for college at all.
The biggest mistake that parents can make is not saving anything for college. Even a small amount can help cover the cost of living, books, or other associated expenses. According to a survey by Sallie Mae, more than half of families in the United States have no college savings, whether because they have no spare income or because they are simply allocating those funds elsewhere.
Financial aid can help with the expense of school, but it rarely covers all costs. Most aid today comes from loans rather than grants, so it is still important to save.
Sometimes, parents choose not to save because they think it will negatively impact the amount of financial aid that a child receives. In truth, financial aid is typically calculated using what parents earn rather than what they have saved. Even if parents cannot save the full amount for tuition, anything will help make ends meet so that students can avoid borrowing money down the road.
Parents should start saving as early as possible. If possible, making regular, automatic deductions from savings accounts or payroll can keep the college savings account rising without having a negative impact on standard of living. Parents are often shocked by how even modest deductions add up over time.
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Paying for education expenses with 401(k) loans.
When parents feel pinched to cover tuition expenses, they may consider borrowing against the assets that they have in a retirement accounts, such as a 401(k) plan. However, it is important to understand the rules about such a loan.
Sometimes, taking out a loan against a 401(k) will disqualify individuals from company matching programs, which means a lot of lost money in the years to come. In the event of a layoff, individuals often have to repay loans within 60 days.
The same holds true if people choose to leave a company for any other reason. If not repaid within a 60-day period, the loan balance is considered income. This could then detract significantly from student aid.
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Taking on too little investment risk.
Research has shown that most American families that do save for college choose low-risk, low-return vehicles such as certificates of deposit and savings accounts. While this approach can help people feel safer about the money that they are saving, the growth in investments does not even come close to matching the rise in costs of education.
Parents may take the safer route because they do not have a clear understanding of the investment market. These low-return investments are meant primarily for short-term stability rather than long-term growth.
Over the course of the last decade, certificates of deposit and savings accounts earned an average of less than 2 percent per year, while college expenses increased by 5 percent annually. Moderate investment portfolios that include bonds and stocks, including those typically offered with 529 savings plans, would have resulted in significantly higher returns, even when the 2008 stock downturn is included.
At the very least, parents should move their college savings to a 529 plan for the tax benefits. When the savings is used for college expenses, no taxes are assessed. Risk-averse parents may also want to look for a 529 plan that offers an age-based account. As the child gets older, the investment strategy becomes more conservative to minimize risk once college is imminent.
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Ceasing deposits to college accounts once school starts.
Parents can continue to make deposits in a 529 plan even after a child matriculates, continuing to reap tax benefits and making the most of the savings. This additional savings can help cover the costs of subsequent years of college or even graduate or professional school.
To make the most of deposits, parents should check the rules for their states. While the federal income tax benefits will continue in full, some states will put caps on tax deductions related to these plans.
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Using an UGMA or UTMA account.
Not long ago, one of the most effective ways of saving for college was through a custodial or minor’s account, which could be called a Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA). These accounts allowed parents to save money with the tax benefits of a child’s lower tax bracket. Parents would deposit money, choose investments, and be taxed like the child would.
However, the tax rules have changed, making such accounts much less attractive than options such as 529 plans. For high-earning parents, up to a third of the yearly account growth of UTMA/UGMA accounts would be lost to taxes. Also, money in these accounts count as a financial asset for the student and hurt financial aid calculations.