I'm a huge fan of developing an "order of operations" for different financial activities. You may remember last year I highlighted an order of operations for saving for retirement. Basically, start here and work your way down. It's just an easy way to remember the order you should do things. And it works for how to save for college as well!
Saving for your kid's college can be tough, and there are a lot of schools of thought. But they all boil down to something pretty basic. And I created an order of operations for you to remember for it: YES! Yes, it's that simple, but I'm actually talking about Y.E.S.
Okay, enough with the play on words, here's the order of operations for saving for kid's college:
(Y) - You
(E) - Education Savings Accounts
(S) - Savings
Let's break it down a little bit further and explain what I mean.
Note: How to save for college and how to pay for college are two very different conversations. This conversation is about saving for college and the best way to approach it. If you're getting close to needing to pay for college, read our full guide (and order of operations) on how to pay for college here.
Step 1 - You
Saving for your kid's college starts with you (that's the parent). You have to get your own financial life in order before you can help your kids.
When you fly on a plane, the flight attendants make a huge point about making sure you put your own mask on first in an emergency. The reason? You simply can't help others if you're passed out. The same is true with your finances.
I've long said you can't get a loan for retirement, but you can get a loan for school. Before you can save for your children's education, you need to take care of your expenses. You need to pay off your debt, achieve your short-term goals (such as buying a house), and make sure that you're free of student loans. There's no reason to save for someone else's education if you haven't paid off your own education yet!
Then, are you set for retirement? If you're a parent and you're not set for retirement, go read the comments on our article about Parent PLUS Loans and see all the parents that got themselves into trouble before retirement and now have no money because they borrowed to pay for their children's' education.
So, the bottom line is before you can save for your kid's college, you need to take care of yourself.
Step 2 - Education Savings Accounts
Once you've conquered step 1, you can look at education savings account options for your children's education. These are specialized accounts that provide some benefits to help you save for college.
The three main ways that people save for college are:
- 529 Plans
- UGMA/UTMA Accounts
- Roth IRA
There are a couple of other approaches, such as owning savings bonds directly, or even life insurance as a savings account (note: usually a terrible idea).
Here are the pros and cons to consider about these main ways to save (and just like everything else in this article, it's in the order I believe in):
A 529 plan is the premier vehicle to save for your children's college education. It's an account that was specifically designed for college savings, and as a result, it has a lot of benefits. Specifically, the money in the account grows tax-free, and it can be withdrawn tax-free when used for qualified educational expenses (see our full guide to qualified educational expenses here).
Plus, a good amount of states all contributions to a 529 plan to be tax deductible!
- Withdrawals spent on qualified higher education expenses are tax free.
- You can use up to $10,000 per year tax free for K-12 tuition as well.
- You can use up to $10,000 one time for student loan debt.
- Plans are better for FAFSA because accounts owned by dependent students are treated as parent assets and nothing has to be reported on the FAFSA when the funds are withdrawn to pay for college.
- If the child doesn't go to college, there are limited options to use the account tax free.
- Earnings are subject to a 10% tax penalty if the withdrawal is not spent on qualified education expenses.
- Investment strategies are limited by the plan provider.
See our full guide here: What Is A 529 Plan And Where To Open One.
Or, click your state in the map below and see what plans are available to you:
A UGMA or UTMA account is an investment account setup for a minor child. It stands for Uniform Gift/Transfer to Minor Account.
The best way to think about these accounts are they are just standard brokerage accounts - except they are custodial so the parent or guardian is on the account as well (until the child is no longer a minor).
Inside this account, you can invest in basically anything - stocks, bonds, ETFs, mutual funds, etc.
Any gains, losses, or income are all reported on the child's income or tax return.
This account gives maximum flexibility, but there are no tax benefits here.
- Investment flexibility - invest in anything.
- Money can be spent on anything - there are no requirements to use for any purpose.
- There is no limit to how much money can be in the account.
- Earnings and gains are taxed to the child and subject to the “kiddie tax”.
- Custodial accounts are counted as a student asset on the FAFSA, which means they can reduce financial aid awards by a significant amount.
Over the last few years, there's been a small choir of people who've been advocating the use of a Roth IRA to save for college. It's possible, and there are some benefits to using a Roth IRA to pay for college.
There's two approaches here:
- You open a Roth IRA for a child (who also must have earned income to even be able to, which is a tough bar to clear in the early years).
- You use a parent's Roth IRA.
Since we're talking about college savings, I'm going to assume it's the first approach. I really dislike the second approach - going back to Step 1 (You in Y.O.U). Don't take money out of your own retirement account to pay for a child's college. The only rare exception would be if you have a multi-mutli million dollar Roth IRA and it doesn't matter. But you probably aren't reading this article if you do.
So, assuming you have a child with a Roth IRA and they have some money in it. Here's the pros and cons:
- Contributions can be withdrawn at any time for any reason.
- The early withdrawal 10% penalty is waived if the money is spent on higher education expenses.
- The value of a retirement account is not counted as an asset on the FAFSA.
- Wide range of investment options.
- A child must have earned income, which is very limited in early years.
- Withdrawals from a Roth IRA to pay for college is counted as base-year income on the FAFSA. So it may not impact financial aid in year 1, but it will in subsequent years.
If you're considering an IRA, check out our list of the best places to open a Roth IRA.
Other Education Savings Options
As we mentioned above, there are other savings options as well. I wanted to briefly touch on a few. I want to note, these are "old school" approaches that don't really work well today for a variety of reasons (fees, costs, ease of use, etc). But when grandpa wants to talk, we better listen and understand. So here goes:
Coverdell Education Savings Plans - Coverdell ESAs were one of the original education savings vehicles. But over the years, as 529 plans have expanded in usage, Coverdells have become less attractive. They still have some potential for K-12 education expenses (because unlike 529 plans, Coverdells don't have a limit on using the funds for K-12 education), but when talking about college savings, 529 plans win. However, with their low contribution limits, age limits, and income limits, there are just better options. Learn more about Coverdell Education Savings Plans here.
Series EE and I Savings Bonds - These old school investments are a viable way to save for college. But they don't earn much interest, and they can be a pain to deal with. The benefit of these is that they are state and Federal tax free when used for qualified higher education expenses.
Whole Life Insurance - Some insurance salesmen may try to sell you a whole life policy and say that the cash value of the policy would grow over 18 years and be a great way to save for college. Just don't do it. You don't need life insurance on your children. The cash value aspect is a crappy savings or investment account. And you're going to be paying a lot in fees for the privilege of this.
While every situation is different, you should find a education savings account that works for you and your child.
Step 3 - Savings
Finally, after you start funding an education savings account, you should just focus on savings in general. By this, I mean you should dedicate a specific amount each year to the education savings account, and then save in a general account for yourself beyond that.
For example, maybe you want to contribute $5,000 per year to your child's education savings account. After that, just put the rest in savings. The reason? By the time your child goes to college, you'll have a nice nest egg in the education savings account, and you'll also have a nice amount in your own savings to pay for things beyond education.
If you plan on helping your student (like most parents do), you have to remember that there are more costs than just education. Education savings accounts (like 529 plans) are great, but the withdrawals are limited to education expenses if you want the tax benefits. But, what about travel costs for your student? Or buying a car? Or helping with rent? Or paying for a cell phone? Or getting them a laptop?
All of these expenses can't really come from the education savings account. That's why it makes a lot of sense to keep a nice bit of savings aside for your child's other expenses that can't be covered by education savings accounts.
Where To Find The Money To Save For College
Now that you have a basic understanding of the order of operations - it doesn't help you at all if you also can't find the money to save for college. Beyond the technical details, this is the more challenging aspect of the equation.
However, it's important to remember that paying for college is a pie - made up of lots of slices. The slices include the parent's income, the student's income, education savings (like we're covering right now), student loans, and more.
The goal, of course, is to save as much as possible so you can minimize debt.
Here's where to start, and the amazing thing is, you don't need to find the money in your own budget. There are a few great ways to find money to save for college where other people pay!
529 Plan Gifting
My number one favorite way to get money to save for college is to have it gifted to my children. It sounds a bit crazy, but it's honestly so much easier than you would believe.
You child will have several special occasions per year: birthday and Christmas. Each one of those events has huge potential to beef up your 529 plan. Some families may have relatives (such as grandma) that wants to give a check anyway. That's easy - send it straight to their 529 plan.
But what about everyone else? Ask them to contribute to the 529 plan in lieu of gifts. And it's a really easy ask - don't spend $25 on a toy at Target that will get tossed out or break a week later. Take that same $25 and let it grow for their college.
If you have a birthday party, you can print that on the invite. You can also use an amazing tool like Backer to make gifting easy. You setup your Backer 529 account (or connect it to your existing 529 account), and you can create a custom website that allows easy online gifting. For example: backer.com/kidsname.
Don't worry, your kids will still get gifts. Mom, dad, siblings, Santa. They'll still walk away with 5 or so widgets to play with, but $100s in their college savings account. Plus, now mom and dad doesn't have to deal with so much junk or saving for college.
If you do this every year from birth to teens, you'll see a huge amount of money accumulate and grow in their account.
529 Cash Back Rewards
Another of my favorite ways to save for college is to earn cash back rewards for the spending that you already do!
Well, instead of just earning cash back generically, what if you could earn money into a 529 plan for your children for your normal spending? You definitely can!
For example, Backer has a Backer Bucks program - which is an online shopping portal where you can earn cash back rebates into your 529 plan for your normal online shopping. They even have services that you may use (like tax preparation) that would earn you cash into a 529 plan.
If you're anything like my family and online shopping, that would add up to $500 or more per year!
You can also get a credit card that pays cash back rewards into a 529 plan. For example, Fidelity has a Signature Visa Rewards card that pays 2% cash back. You can have that cash back deposited into a Fidelity 529 plan. Another easy way to earn cash back rewards for your normal shopping!
Note: not everyone should open a Fidelity 529 plan, as you may get better benefits by opening a 529 plan in your state.
This one is specifically for older children (13+). They can start saving for college as well, and they can do it by going out and earning scholarships.
I'm a huge fan of scholarships because they are relatively untapped sources of savings. Sound crazy? Let me explain.
Most scholarships don't get a lot of qualified applications - so your odds of winning a scholarship are pretty good. It may not feel like it, but simply following the directions and doing the work will get you a really good chance at earning money.
For example, our Side Hustlin' Student Scholarship attracts about 100 applicants each year. However, about 80 of the applicants each year get instantly disqualified for not following the directions (word count, grammar/spelling, including a headshot, or even making it a .doc file). So, your real odds are 1-in-20.
Then, it simply becomes a game of statistics - you just need to apply to more scholarships to earn more money. Sadly, most students apply to just one or two. It takes time and effort, and most students don't start early enough.
If you want to really boost savings here, you should shoot to apply for 40 scholarships - 10 each year of high school. It's possible!
A Recap of YES
So, there you have it - the order of operations for saving for your child's college expenses is Y.E.S.
Y - You: You have to take care of yourself first
E - Education Savings Account: You an appropriate education savings account
S - Savings: Make sure you save a little beyond the education savings account for other expenses
Then, you combine this order with our tactics for finding money to save, and you have a complete guide on how to save for college.
It's possible. It's not always easy. And it does take time. But you can do it!
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.