Saving for College: Frequently Asked Questions

Table of Contents

• When should I start saving for my child’s education?
• How much will my child’s college education cost?
• How should I invest my child’s college fund?
• What is the American Opportunity Tax Credit?
• What is the “kiddie tax?”
• What is a Coverdell Education Savings Account and who is eligible for one?
• If you have insufficient savings for your child’s education, what should you do?
• What types of grants are available for college?
• What types of loans are available for college?
• How can I increase the amount of financial aid my child is entitled to?
• How can I save taxes on college savings?

When should I start saving for my child’s education?

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 their college education 18 years from now. If you start putting away money immediately, you’ll need to save $3,500 per year for 18 years, assuming an after-tax return of 7 percent. On the other hand, if you put off saving 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 when it comes to the type of investment you’ll use. You’ll be able to put at least part of your money in equities, which, although riskier in the short run, may be better able to outpace inflation than other investments in the long run.

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How much will my child’s college education cost?

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—including tuition, fees, board, personal expenses, books, and supplies—for the average four-year private college were about $57,570 per year and about $27,940 per year for the average four-year in-state public college.

However, these amounts are averages: the tuition, fees, and board for some private colleges can exceed $80,000 per year, whereas the costs for a state school can often be kept under $10,000 per year. It should also be noted that in 2022–23, the average amount of grant aid for a full-time undergraduate student was about $8,690 at four-year public schools and $24,770 at four-year private schools. More than 75 percent of full-time students at four-year colleges and universities receive grant aid to help pay for college.

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How should I invest my child’s college fund?

As with any investment, you should choose investments that will provide you with a good return and meet your level of risk tolerance. The ones you choose should depend on when you start your savings plan. The mix of investments used when your child is a toddler should be different from those used when your child is age 12.

The following are often recommended as investments for education funds:

• Series EE Bonds: These are relatively safe investments. They should be held in the parents’ names. Under certain conditions, interest on qualified U.S. savings bonds may be excluded from federal income tax when used for qualified higher education expenses. Eligibility depends on the bond, the taxpayer’s income, filing status, and other requirements.
• U.S. Government Bonds: These investments may offer returns different from those of certificates of deposit or Series EE bonds. If you use zero-coupon bonds, you can time the receipt of the proceeds to fall in the year when you need the money. A drawback is that selling before maturity could result in a loss. Accrued interest may also be taxable even if you do not receive it until maturity.
• Certificates of Deposit: These are generally considered lower-risk investments, but their returns may not keep pace with inflation. Interest is generally taxable. They may be suitable for risk-averse investors or shorter investment horizons.
• Municipal Bonds: Assuming the bonds are highly rated, their tax-free interest may provide an acceptable return for investors in higher income tax brackets. Zero-coupon municipal bonds can be timed to mature when you need the funds.

Be sure to convert the tax-free return quoted by sellers of such bonds into an equivalent taxable return. Otherwise, the quoted return may be misleading. The formula for converting tax-free returns into taxable returns is as follows:

Taxable-equivalent return = Tax-free return ÷ (1 − your marginal tax rate)

For example, if the return on municipal bonds is 1 percent and you are in the 32 percent tax bracket, the equivalent taxable return is approximately 1.47 percent (1 percent divided by 68 percent).

• Stocks: An appropriate mutual fund or portfolio containing stocks can provide a higher potential return than bonds, but also involves greater risk. Stock mutual funds may provide growth over the long term. Income and balanced funds may meet the investment needs of those who begin saving when the child is older.

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What is the American Opportunity Tax Credit?

The American Opportunity Tax Credit (AOTC) provides a tax credit for certain qualified higher education expenses during the first four years of post-secondary education. The maximum credit is $2,500 per eligible student, subject to eligibility requirements.

Income limits: Eligibility depends on modified adjusted gross income (MAGI), filing status, and other requirements. The credit is generally reduced at higher income levels and is unavailable above the applicable income limits. Check current IRS guidance for the tax year in question.

Amount of credit: For eligible taxpayers, 40 percent of the AOTC may be refundable, up to $1,000, subject to restrictions.

Which costs are eligible? Qualified expenses generally include tuition, required fees, and course materials needed for enrollment or attendance at an eligible educational institution. Books, supplies, and equipment may qualify whether or not they must be purchased from the institution.

Related expenses generally do not include room and board, student activities, athletics that are not part of a degree program, insurance, transportation, or personal, living, and family expenses. Student activity fees may qualify if payment is required for enrollment or attendance. For expenses paid with borrowed funds, the expenses are generally counted when paid, not when the borrowing is repaid.

You generally cannot claim both a tax credit and a deduction for the same higher education expenses. Expenses paid with tax-free scholarships, Pell grants, or employer-provided educational assistance cannot also be used to claim a credit to the extent the law prohibits it.

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What is the “kiddie tax?”

In the past, parents would invest in a child’s name in order to shift income to the lower-bracket child. However, the addition of the “kiddie tax” mostly put an end to that strategy.

The kiddie tax rules can cause certain unearned income belonging to a child to be taxed using the parent’s tax rate. The applicable thresholds and rules vary by tax year and may depend on the child’s age, student status, income, and other circumstances.

These rules apply to unearned income. If a child has earned income, that income is generally taxed under the rules applicable to the child’s own tax situation.

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What is a Coverdell Education Savings Account and who is eligible for one?

A Coverdell Education Savings Account (ESA), also known as a Section 530 account, is a tax-advantaged account designed to help families save for qualified education expenses.

Under the rules described in the original guide, the annual contribution limit was $2,000 per beneficiary. Contributions are not deductible, but earnings may grow tax-free and qualified withdrawals may be tax-free. Eligibility and contribution limits depend on applicable rules, including the contributor’s modified adjusted gross income.

Only cash can be contributed to a Coverdell ESA, and contributions generally cannot be made after the beneficiary reaches age 18, subject to special-needs beneficiary rules.

Eligible individuals may establish and contribute to an account for a beneficiary. The beneficiary does not necessarily have to be the contributor’s dependent or relative, but the annual contribution limit applies across contributions made to accounts for that beneficiary.

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If you have insufficient savings for your child’s education, what should you do?

Many families find themselves in the same situation. Fortunately, there are ways to generate additional funds both now and when your child is about to enter school:

• You can start saving as much as possible during the remaining years. However, unless your income level is high enough to support an extremely stringent savings plan, you will probably fall short of the amount you need.
• You can take on a part-time job. However, this will raise your income for purposes of determining whether you are eligible for certain types of student aid. In addition, your child may be able to take on part-time or summer jobs.
• You can tap your assets by taking out a home equity loan or a personal loan, selling assets, or borrowing from a 401(k) plan. Carefully consider the risks, costs, and potential impact on retirement savings before borrowing.
• You or your child can apply for various types of student aid and education loans.

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What types of grants are available for college?

Grants. Grants are among the most desirable forms of financial aid because they generally do not have to be repaid. They may be awarded by governments, schools, and other organizations. Some grants are need-based and others are not.

• The Federal Pell Grant Program offers federal aid based on financial need and applicable eligibility rules.
• State education departments may make grants available. Inquiries should be made with the relevant state agency.
• Employers may provide education subsidies.
• Private organizations may provide scholarships. Inquiries should be made at schools and with relevant organizations.
• Most schools provide aid and scholarships, both need-based and non-need-based.
• Military scholarships may be available to those who enlist in the Reserves, National Guard, or Reserve Officers’ Training Corps (ROTC). Inquiries should be made with the relevant branch of service.

Don’t assume that middle-income families are ineligible for need-based aid or loans. Whether a family qualifies depends on factors such as the cost of the college, family circumstances, and the financial aid program’s eligibility rules.

Try negotiating with your preferred college for additional financial aid, especially if it offers less than a comparable college.

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What types of loans are available for college?

There are various student loan programs available. Some are need-based, and others are not. The original guide lists the following loan types:

• Stafford Loans: These were federally supported student loans. Federal student loan programs and eligibility rules have changed over time, so check current federal student aid guidance for the programs available to new borrowers.
• Perkins Loans: These were need-based federal loans administered by participating schools. The federal Perkins Loan Program ended for new lending, although some borrowers may still have existing loans to repay.
• Parent PLUS Loans: These are federal loans for eligible parents of dependent undergraduate students, subject to current program requirements.
• School-provided loans: Some schools may offer institutional loan programs. Inquiries should be made at the school’s financial aid office.

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How can I increase the amount of financial aid my child is entitled to?

Here are some strategies that may help your family understand and plan for financial aid eligibility:

• Consider how assets are held.
  The ownership and treatment of education savings can affect aid eligibility. The original guide recommends keeping education funds in parents’ names, but the effect depends on the applicable financial aid methodology and the type of account.
• Plan income carefully.
  Financial aid calculations may use income information from an earlier tax year. In the years immediately prior to and during college, understand how taxable income and asset decisions may affect eligibility. Strategies discussed in the original guide include:
  1. Deferring capital gains where appropriate.
  2. Selling investments that have losses, after considering the financial consequences.
  3. Reviewing business income and compensation arrangements with a qualified adviser.
  4. Understanding how retirement plan or IRA distributions may affect aid calculations.
  5. Paying federal and state taxes according to applicable deadlines.
  6. Considering whether paying off credit cards and other consumer loans is appropriate for your financial situation.
  7. Reviewing tax-deferred savings options, such as eligible retirement plans or annuities.
• Explain financial hardships.
  If you have financial hardships that are not clear from the application, explain them to the financial aid office. The officer may be able to advise you about the appropriate appeal or review process.
• Understand independent student status.
  A student’s status can affect whether parental income and assets are considered. Federal student aid rules specify the criteria for independent status, which may include age, military service, dependents, orphan or ward status, graduate or professional study, and certain marital circumstances. Check current eligibility rules before making decisions.

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How can I save taxes on college savings?

If you decide to invest in your child’s name, here are some tax strategies discussed in the original guide. Their suitability depends on current tax rules and your family’s circumstances:

• You may be able to shift a limited amount of investment income to a child, but the kiddie tax rules can apply to unearned income.
• You can consider U.S. Savings Bonds, subject to the requirements for any available education-related tax exclusion.
• You can consider equities that pay relatively small dividends but have potential for long-term appreciation. Investment values can fall, and dividend income and gains may have tax consequences.
• If you own a family business, you may be able to employ your child for legitimate work. Wages must be reasonable for the work performed and properly documented. Tax treatment depends on the business structure, the child’s age, and applicable federal and state laws.

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Editorial note: This article includes historical college-cost figures and tax thresholds from earlier tax years, including 2022–2023, 2023, and 2025-era guidance. Education costs, financial aid programs, contribution limits, tax credits, and eligibility requirements can change. Verify current information with the relevant official agencies or a qualified tax professional before relying on it for financial planning.