By Matt Watson
A C-note isn’t going to pay anyone’s college tuition, but it could certainly pay for a few textbooks if invested tax-free for 18 years. Assuming a conservative 5% return over time, $100 compounded monthly will become $245 by the time a newborn is ready to go to college.
That’s the idea behind Colorado’s First Step program, provides $100 to fund a new 529 college savings account for a child born or adopted between Jan. 1, 2020, and 2040.
The state legislature passed the Child College Savings Accounts bill in 2019 to incentivize parents to save for college before their children even enter preschool.
“We want to show how that magic of cumulative interest can work for (families) so they can better afford the higher-education needs of the child in 18, 19 or 20 years,” Gov. Jared Polis said in a Jan. 21 speech to the Colorado Business Roundtable.
The program is operated by CollegeInvest, the not-for-profit division of the Colorado Department of Higher Education that administers the state’s 529 savings plans. To claim the funds, all a parent needs to do is open an account using one of CollegeInvest’s four plans before their child’s fifth birthday, name their child as the beneficiary and apply online at collegeinvest.org/first-step with the child’s birth certificate (or adoption documents) and CollegeInvest account number handy.
The state tracks births monthly and updates its database at the middle of each month, so parents can apply 2 to 6 weeks after their child is born or adopted. For example, those who have a child in January 2020 can start applying Feb. 18, 2020. CollegeInvest says it will deposit a $100 contribution into qualified applicants’ accounts within 30 days.
Can $100 really make a difference in the education prospects for a child? The research says yes.
Any amount of college savings will make a child more likely to go to college and graduate, according to a 2017 report from the Institute for Higher Education Policy. IHEP found that children with college savings between $1 and $499 were three times more likely to attend college and four times more likely to graduate than those with no savings.
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Financial experts recommend 529 savings plans because, unlike mutual funds or other investments, they grow tax-free and can be withdrawn tax-free if the funds are spent on qualified educational expenses, such as tuition, fees, books, computers and, in some cases, room and board and other supplies. There aren’t annual contribution limits on 529 savings plans, either, unlike a Coverdell Education Savings Account.
“The primary benefit is all of the money that gets put into a 529 grows on a tax-deferred basis, which means the money’s going to be worth significantly more when it’s eventually pulled out,” said Paul Camp, chair of the Finance Department at Metropolitan State University of Denver. “That’s an immediate benefit to Mom and Dad when the amount gets spent on educational expenses. They’re very powerful savings vehicles for that purpose.”
Another reason saving over time is critical: The average cost of college in the U.S. has been rising significantly over time. A CNBC report shows tuition and fees for in-state students at public colleges jumped 55% between 2009 and 2019 after states cut funding during the recession. If those trends continue, a school that costs $20,000 per year now could cost close to $50,000 per year by the time today’s newborns are graduating from high school.
Camp recommends that parents save at most half of what they expect to pay for college in a 529 plan, since the funds can be used only for educational expenses and students can also pay for school with scholarships, financial aid and student loans. He also suggests thinking of saving for college as four individual payments for each year of college, paid simultaneously until the child enters school when you can peel off a payment each year; that gives you three additional years to save compared to having an entire college education paid for up front.
As a general rule of thumb, Camp says to be careful about putting more than 50% of what you think you’ll need in a 529 account. While the tax-free growth and withdrawal are a great deal when it comes to paying for college, if you don’t end up using the money on educational expenses, you’ll pay a 10% penalty to withdraw and pay income tax on the funds too.
“The temptation is, ‘Let's put as much into this account as we can possibly put in there.’ But then the concern is that you get carried away and you overfund the thing. Then if you have a kid that’s getting real good grades in high school and qualifies for a bunch of scholarships, you’ve got money left over that you can’t take out without paying taxes on it,” Camp said.
Account holders can withdraw funds equal to the beneficiary’s scholarship amount without paying the 10% federal penalty assessed on other unqualified withdrawals, but they will pay income tax on the withdrawal. The other option for unused funds is changing the beneficiary to another relative, such as a sibling or grandchild.
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As urgent as it may seem to save for college, Camp also says parents should make it a higher priority to save for themselves. If parents neglect their retirement funds, their children will end up needing to bail them out.
“As a general principle, save for retirement before college. There are multiple different avenues that people can use to pay for college, but saving for retirement is the only way to get that done. There’s no work-study in retirement,” Camp said. “If Mom and Dad don’t have savings to rely on at age 65 or 67, they’re going to be stuck.”
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