Under ideal conditions, a parent who starts saving for a child’s college education from birth will save enough money to pay for one-third or more of the child’s future college costs. But, sometimes the college savings plan falls short, because the parents get a late start on saving for college or because the investments don’t earn enough of a return or the parent saves an insufficient amount. Sometimes the parents just want to know whether the college savings plan is on track to reach the parents’ college savings goal.
If the parents start saving for college when the child is born, there are a few key milestones that can be used to evaluate progress toward to the college savings goal, assuming a typical average annual return on investment.
When the child is 6-years old, the earnings portion of the college savings should be the equivalent of one additional year’s worth of contributions. By the time the child enters high school, the earnings will have added the equivalent of more than five years’ worth of contributions.
When parents start saving from birth, about a third of the college savings goal comes from earnings. When parents wait until the child enters high school, less than a tenth of the college savings goal comes from earnings.
The milestones do not depend on the amount of the college savings goal, as the monthly contribution and the progress toward the college savings goal are both proportional to the college savings goal.
The parents cannot compensate for a late start in saving for college by investing in a riskier mix of investments. Not only is adopting a higher risk profile not advisable, but it will not be effective in making up the shortfall. For example, if the parents save $250 a month for 17 years at 4% interest, they will accumulate about $73,116 for college. If the parents wait until the child is 5 years old to start saving for college, the interest rate will need to increase to 10.6% to reach the same college savings goal with the same monthly contribution. If the parents start saving for college when the child enters high school, the interest rate will have to be 74.6% to reach the same goal with the same monthly contribution.
The only practical way to reach the same college savings goal is to increase the amount saved each month. If the parents don’t start saving until the child is 5 years old, they will need to save about three-fifths to two-thirds more per month than if they had started saving from birth. For example, $395 a month instead of $250 a month for an in-state public 4-year college, about 60% more per month. If they wait until the child enters high school to start saving, they will need to save six times as much per month. For example, $1,403 a month instead of $250 a month, 5.6 times as much.
When parents start saving when the child is older, there is less time available for the savings to grow and the earnings to compound. Obviously, the parents could use a college savings calculator to figure out how much to save per month. But, there are also rules of thumb that can provide good estimates.
One approach involves a linear approximation. If the earnings rate is 0%, then the total savings to date will be the same as the total contributions to date. The total contributions are equal to the product of the number of monthly contributions and the monthly contribution amount. This can be used to calculate how much the parent should have contributed since birth, as the amount of a catch-up contribution. The contribution shortfall can also be spread across the remaining time until college enrollment, to calculate the increase in the monthly contribution amount.
For example, suppose the parent should have been saving $250 per month since the child’s birth, but starts saving for college after the child turns five-years old. The total contributions from birth should have been 5 years x 12 months/year x $250 per month = $15,000. The parent could make a lump sum contribution of $15,000 to catch up. Alternately, the parent could spread this amount over the remaining 12 years before the child enrolls in college. That means contributing $15,000 / 12 years / 12 months per year = $104 more per month, for a total monthly contribution of $354.
Simplifying, the increase in the monthly contribution is the product of the monthly contribution amount with the ratio of the number of years skipped to the number of years remaining. For example, the increase in the monthly payment is 5/12 x $250 = $104.
This is an approximation that underestimates the actual amounts, due to the impact of interest earnings. If the interest rate on savings is 4% instead of 0%, for example, the parent would have saved $16,630 in the first five years, including interest, instead of just $15,000. To reach the college savings goal with only 12 years left, the parent could either make a lump sum contribution in this amount or increase the monthly contribution amount to $395 ($250 plus $145). Both figures are a bit higher than the figures estimated by the linear approximation. The error in the estimate will increase as the time remaining until college enrollment decreases.
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