When today's 18-year-old college freshmen were born, the average tuition at a public university was $3,111. At a private university, it was $13,785. Since then, the price of college has risen far faster than inflation: Tuition has tripled at public universities and more than doubled at private universities.
That creates a dilemma for today's parents. It's a safe bet that college will be more expensive by the time their kids get to college. But they don't know how much more expensive, which makes it hard to figure out how much to save.
One way to get a ballpark figure is to assume that college costs will continue increasing at their current rate. It already costs about $60,000 per year to attend a top-tier private college. If college costs keep climbing, that college will cost more than $100,000 per year in 2030. To afford it, the parents of a 3-year-old would need to begin investing about $1,300 per month.
But the way the financial aid system works actually makes the decision a bit simpler for the average parent. That's because you'll come out ahead financially if you max out tax-free retirement savings options before putting any money in a college savings fund. And since the contribution limits on IRA and 401(k) accounts are higher than most people can afford, that means most parents should just focus on saving as much as possible for retirement.
You probably won't have to pay the sticker price
The most expensive private colleges now cost more than $60,000 per year. But you shouldn't panic, because most people don't pay close to that amount. After financial aid, the typical family pays $23,550 per year at a private college and $12,830 at a public university.
The most prestigious colleges have financial aid programs that reach well into the upper middle class. Stanford's tuition is free for families making less than $125,000 per year. At Harvard, families making up to $180,000 pay a percentage of their income rather than the full tuition.
Financial aid programs this generous are rare, but financial aid for students even from well-off families is not. About two-thirds of private college students get some kind of financial aid from the college itself, and that includes more than half of students from the wealthiest quartile, those from families with an income of over $106,000 per year. On average, students at nonprofit colleges get about $18,870 per year in grants and tax benefits.
Whether you've saved money for your child's education will obviously affect whether they're eligible for grants based on financial need. Assets saved in the child's name count against their financial aid eligibility more than assets in the parents' names.
But need-based financial aid isn't the only kind — there are also scholarships based on academics, and more nebulous "merit-based aid" that sometimes is just used to attract students to attend one college rather than another.
Save for retirement first, college second
It might seem like you face a difficult choice between saving for your child's education and your own retirement. But almost all financial experts say this isn't actually a tough call: You should save for retirement first. Before you start putting money away for college, make the maximum contributions to your retirement accounts, such as a 401(k) and an individual retirement account.
There are three reasons for this. One is that it's easier to find another way to afford college — grants, loans, or a cheaper option, like transferring from a community college to a four-year university — than it is to support yourself in retirement.
Second, retirement accounts aren't counted when colleges and the federal government figure out eligibility for financial aid. The government expects parents to contribute up to 6 percent of their available assets, including investments, per year to pay for college, but investments in 401(k)s and IRAs are excluded. The additional financial aid application that some colleges expect, the CSS/Financial Aid Profile, also doesn't count retirement assets, although it does ask about them.
But if you're still torn, a retirement vehicle called a Roth IRA allows you to have the best of both worlds: retirement savings that can still be tapped to pay college costs. Each person can contribute up to $5,500 in after-tax money to a Roth IRA. Roth IRA rules allow you to withdraw these contributions — but not any subsequent earnings — without penalty.
Over 18 years, you'll be able to set aside about $100,000 — per parent — that will be available for use, tax- and penalty-free, once your kids reach college age. These funds won't count against your child in financial aid calculations, and if they're not needed for college expenses you can leave them in the Roth IRA until you reach retirement age.
So if you're worried about paying for college, it might make sense to fund a personal Roth IRA before funding an employer-supplied 401(k) account. (But don't skip your 401(k) if your employer is matching contributions — see here for more details.)
Save in tax-advantaged college savings accounts
Only after you've saved enough to max out both your 401(k) and IRA accounts — about $23,500 per year under current law — should you start contributing to a college-specific savings fund. The best option is generally a tax-advantaged college savings account known as a 529 plan. Contributions aren't tax-deductible, but earnings on the investments grow tax-free and are never taxed if they're used to pay educational expenses.
Anyone — friends, aunts and uncles, and grandparents — can contribute to a 529 for your child. Typically, you can contribute up to $14,000 per year without incurring the federal gift tax; in some cases, you can give up to $70,000 in one year without paying the federal gift tax, because the gift is treated for tax purposes as if it were spread across five years.
That tax advantage might not survive forever, particularly if there's any kind of broad tax reform in the next decade. But the pushback to President Obama's proposal in January to tax 529 plans suggests that they're politically popular enough to stick around.
Some colleges offer prepaid tuition plans
If you want to figure out how much to save, this calculator, which assumes that college costs will continue to grow at 4 percent per year and you'll get a 6 percent rate of return on your investment, tells you how much you'd need to put away to pay for four years at a college of your choice.
If that's too much uncertainty for you, it's also possible to lock in today's tuition prices through a special type of 529 account known as a prepaid tuition plan. Those plans allow families to pay tuition today to be used years down the road, after their children enroll in college.
Right now, if you live in Virginia, you could buy a semester at the University of Virginia or another in-state public college for a child under 4 years old for $8,100; for a high school freshman, you could buy a semester at UVA for $7,500. Part of that expenditure would be tax-deductible.
Many states have some version of this plan; there's also a prepaid tuition plan available for private colleges. If your child doesn't end up going to a participating state school, it's possible to get a refund and use the money elsewhere.