Your Child's Education: How To Finance It

With the costs of a college education rising every year, the keys to funding your child's education are to plan early and invest shrewdly. However, there are steps you can take if you get a late start. Moreover, there are a number of effective techniques for increasing financial aid opportunities and reducing taxes. Here are guidelines geared to parents whose children are no older than elementary school age.

College is expensive and proper planning can lessen the financial squeeze considerably— especially if you start when your child is young. Getting an early start on saving is basic to funding your child's education. The earlier you start, the more you'll benefit from the compounding of interest.

Planning Aid: For an estimate of the amount of money you would have at the time your child enters college if you begin saving now, use a college savings calculator.

When should you start saving? This depends on how much you think your children's education will cost. The best way is to start saving before they are born. The sooner you begin, the less money you will have to put away each year.

Suppose you have one child, age six months, and you estimate that you'll need $120,000 to finance college 18 years from now. If you start putting away money immediately, you'll need to save about $3,500 per year for 18 years (assuming an after‑tax return of 7%). If you wait until the child is six years old, you'll have to save almost double that amount every year for twelve years.

Another advantage of starting early is that you'll have more flexibility in your investments. You'll be able to put at least part of your money in equities, which—although riskier in the short‑run—are better able to outpace inflation over time.

How much will your child's education cost? It depends on whether your child attends a private or state school. According to the College Board, for the 2022–23 school year the total expenses—tuition, fees, board, personal expenses, and books and supplies—were about $57,570 per year for the average four‑year private college and about $27,940 per year for the average four‑year in‑state public college. These are averages: some private colleges can exceed $80,000 per year, while state schools can be kept under $10,000 per year.

In 2022–23 the average amount of grant aid for a full‑time undergraduate student was about $8,690 and $24,770 for four‑year public and private schools, respectively. More than 75% of full‑time students at four‑year colleges and universities receive grant aid to help pay for college.

Planning Aid: If you're trying to estimate future costs, a common approach is to assume school costs will grow about two percentage points above inflation. To be conservative, you might assume at least 4% per year.

As with any investment, choose options that provide a good return and match your risk tolerance. Your mix should reflect when you start—saving with a toddler allows for a more growth‑oriented mix than starting at age 12.

• Series EE Bonds. Extremely safe. (Special tax treatment may apply when redeemed for qualified college costs.)
• U.S. Government Bonds. Safe with relatively higher returns. Zero‑coupon bonds can be timed to mature when funds are needed; note potential losses if sold early and taxation of accrued interest.
• CDs. Very safe but often yield below inflation; interest is taxable.
• Municipal Bonds. Tax‑free interest may be attractive in higher brackets; compare tax‑equivalent yields. Zero‑coupon munis can be timed for later needs.
• Stocks / Mutual Funds. Equity funds can provide superior long‑term returns; income/balanced funds may suit late starters.
• Deferred Annuities. Offer tax deferral but may have higher costs and potential early‑withdrawal penalties before age 59½.

Tax‑equivalent yield formula: tax‑free return ÷ (1 − top tax rate). For example, a 5% municipal yield at a 30% tax rate equals about a 7.1% taxable yield.

If savings are insufficient as college nears, you can still generate funds:

• Increase savings aggressively in remaining years (recognizing practical limits).
• Consider part‑time work for you and/or your student (note possible aid impacts).
• Tap assets via home‑equity or personal loans, selling assets, or 401(k) loans.
• Apply for student aid and education loans (see below).

Generally, exhaust student‑aid loans before other borrowing, though home‑equity interest may be deductible in some cases.

Aid types and rules change frequently. Below are common sources; confirm details as you get close to applying.

Grants & Scholarships

• Federal Pell Grant (need‑based).
• State education department grants.
• Employer subsidies.
• Private scholarships (check with schools).
• School‑provided aid (need and merit based).
• Military scholarships (Reserves, National Guard, ROTC).

Don't assume middle‑income families are ineligible—need depends on school cost and family size, among other factors. Negotiate if competing offers differ.

Loans

• Stafford (Direct) Loans: Federal, subsidized (need‑based) and unsubsidized versions.
• Perkins Loans: Federally provided, school‑administered, need‑based (where available).
• PLUS Loans: Federal loans to parents; also some supplemental student loan options.
• School‑based loans (inquire with aid office).

Work‑Study

Federally funded, need‑based campus employment with partially subsidized pay; generally does not reduce calculated need for grants/loans.

File the financial aid application (with tax returns) via the school's aid office. Awards consider income, family size, number in college, and assets.

How To Increase The Amount Of Financial Aid

• Avoid putting assets in your child's name. Aid formulas may reduce eligibility by up to 35% of a child's assets and 50% of a child's income, versus roughly 5.6% of parental assets and 22–47% of parental income.
• Reduce taxable income in the base years: defer gains, harvest losses, time bonuses, avoid retirement distributions, make timely estimated tax payments, and pay down consumer debt.
• Use tax‑deferred vehicles such as 401(k)s, other retirement plans, or annuities.
• Document financial hardships in your aid application; aid officers can exercise professional judgment.
• Consider independent‑student status where applicable (e.g., age ≥24, veteran, dependents, orphan/ward of court, graduate/professional student, or married and not a dependent on parents' returns).

Because of aid formulas, education funds are often best held in parents' names. In specific cases, keeping investments in a child's name may lower taxes; weigh this with professional advice.

The "kiddie tax" generally taxes a child's unearned income over $2,500 (2023)at the parents' rate for children under 19 (or under 24 if full‑time students). Earned income is taxed at the child's rate. Strategies include:

• Shift just enough assets to create about $2,500 of taxable income to an under‑19 child.
• Buy U.S. Savings Bonds in the child's name maturing after age 19.
• Favor equities with low dividends but growth potential for younger children.
• Employ your child in a family business (earned income isn't subject to the kiddie tax; may also avoid FICA in a sole proprietorship when the child is under 19, if rules met).

The kiddie tax may not apply if a student over 18 has earned income exceeding half of their support. Report kiddie tax via Form 8615. Parents may not use Form 8814 if the child has taxable earned income requiring their own return.

U.S. Department of Education (financial aid information): 1‑800‑USA‑LEARN(1‑800‑872‑5327)