From Nap to Frat:

The Five Rules of College Savings

                                                                                          

Imagine you have a two-year old at home—as I do—and you finally get her down for a nap.  Your next step is to plop down on the couch, even if just for a few minutes.  While the house could use a good cleaning and the trash needs to be taken out, you need a few minutes to recharge.  You pick up a magazine to relax, but quickly come across a frightening number that jolts you back to reality:  $432,000.

 

That’s one estimate for the cost of a four-year degree from a private school in 16 years.  While there are other reasonably calculated guesses for the future cost of a college education, there are two certainties: college is incredibly expensive now and will be even more so when that two-year old enters the class of 2026.

 

You: Because of inflation, right?

 

Mostly.  The cost of a college education has historically increased faster than the general rate of inflation. In other words, even though nearly everything goes up in cost each year, college education has consistently increased by an even higher rate.  Most experts expect that trend to continue in the future.

 

Some people have asked me how much they need to save in order to pay for their kid’s education.  Of course, that all depends on the assumptions you use.  But if your goal is $432,000 for your two-year old, you’ll need to put away over $1,100 at the beginning of each month assuming an 8% rate of return.

 

You:  Just eleven hundred bucks a month?  Piece of cake.

 

You serious?

 

You:  Let’s say I am.

 

Okay, great, but don’t forget you may have another child.  Then there’s grad school, paying off the student loans from your education, saving for your own retirement, your mid-life crisis . . .

 

You:  Yeah, okay. $1,100 per month isn’t going to happen.

 

In fact, for most people, saving 100% of the anticipated expenses for their child’s education is going to be a struggle.  But don’t get upset.  There are other options. For one thing, financial aid can provide valuable assistance and doesn’t seem to be going away.  Most students get some form of financial aid these days. In addition, your kid might not go to Harvard or another very expensive private school.  They might go to a high quality public school or a less expensive private school.

 

Gary:  Or they might go to my alma mater, Halpern State University in Fond du Lac, Wisconsin.  Go Halps!

 

There’s no such school.

 

Gary: I have got to update my resume.

 

I don’t think update is the right word there. Regardless, the first

key takeaway as you think about saving for your child’s education is:

 

RULE 1: YOU COME FIRST

 

It’s difficult for many parents to accept that they come first, but—at least financially speaking—your future is more important than your child’s college education.

 

You:  Why?  I love my kids.

 

Of course you do.  But if you ultimately have insufficient funds for your retirement, you’ll be on your own. You can’t get a low interest rate student loan for retirement.  There’s no financial aid office at the country club.

 

So given a choice between saving for retirement and saving for your child’s education, most of your emphasis has to go to your future.  There are other ways for your child to get through school. There aren’t for your retirement.  After all, do you have a traditional pension?

 

You: No, but I have a 401(k) plan.

 

Great, but a 401(k) plan is only valuable if you save money in it.  Are you counting on an unfunded Social Security system to get you through?

 

You: No, not after reading “Beyond Paycheck to Paycheck” anyway.

 

Good. That’s what I thought.  That’s why saving for your retirement is a higher priority than saving for your child’s education.

 

Still, I want you to save something for your child’s education. Get the ball rolling.  Don’t let your child get to 18 with nothing saved on her behalf.  Just like for retirement, it will never be easier to save for that future goal than it is right now. That $1,100 a month number—admittedly ridiculous for most people—will only get higher the longer you delay.

 

RULE 2:  Have your child be part of the process

 

You:  Now? She’s two years old. I’m just trying to keep her from choking on her blocks.

 

No, not now. Now is survival mode. Trust me, I get it.  A financial lesson in our house is trying to have our daughter save one of the bananas for tomorrow.  But your child—mine too—grows up quickly and is learning all the time.  It’s important for her to discover the value of a dollar long before college orientation.  Have her save part of her allowance, the gift from Grandma, or whatever—just teach her to save something.  She’ll learn from you, so set an example.  Teach your child that the whole family is saving.

 

You: Okay, but which accounts should we use?  There are so many possibilities.

 

There are. A list of just about everything I’ve seen positioned as an educational savings device follows. Note, some of these accounts shouldn’t be used for college savings, and we’ll get to those shortly.

 

• UTMA/UGMA Custodial accounts
• 529 College Savings Plans
• Education Savings Accounts
• Roth IRAs/Regular IRAs
• Savings Bonds
• Taxable/Brokerage Accounts
• Annuities
• Loaded Mutual Funds
• Life Insurance Policies

 

RULE 3:  KNOW WHAT NOT TO DO

 

Sometimes it is as important to know what not to do as it is to know what to do.

 

First and foremost, the last three things on the list above just don’t make sense for college funding. I could go on and on as to why, but there’s little point in doing so. Cutting to the chase, annuities, loaded mutual funds, and whole life insurance policies typically have significant and unnecessary fees.

 

Gary: When you say unnecessary—

 

I am talking about it from the perspective of the person saving for college.

 

Gary: Oh, because from my standpoint—

 

Yes, I know.

 

While both Roth and regular IRAs are excellent vehicles for saving, they should be used primarily—if not exclusively—for your retirement. As we will discuss, there are better ways to manage the funds you earmark for college.

 

The principal advantage of using savings bonds for college funding is that, subject to a bunch of annoying restrictions including the timing of when you cash in the bonds and the income level of the bond owner, taxes may be eliminated on the interest earned.

 

The disadvantage for someone saving for the college education of a two-year old is that the expected long-term investment returns from savings bonds are too low compared to the expected higher rate of from stocks. So bonds aren’t the place for you to start saving for the college of a two-year old today.

 

A brokerage (taxable) account isn’t a great idea for college savings either. If you begin investing money earmarked for college funding in a regular account, you won’t be eligible for most of the tax benefits we discuss next.

 

You:  Simple enough. So far, you have provided a lot of information about what not to do. That’s good, as I hate making the wrong choices.  Keep going.

 

Absolutely. A custodial account has two major negatives: You lose control—complete control—over the money when your child reaches “majority.” Depending on your state, your child will most likely reach majority at either age 18 or 21.  Of course, you and I expect that our children will be on the honor roll every semester starting in pre-school and spend their money only on organically-grown nutritional snacks, but there are going to be kids in school who reach age 18 and make choices completely different from the ones their parents envisioned for them just a few years previously.  So, control of the money can be an important consideration.

 

And, while some of the income from such accounts is taxed at your child’s (likely lower) tax rates, recent congressional activity has somewhat reduced this advantage.  Taken together, custodial accounts are not an ideal form of saving for college education.

 

You: So we still haven’t discussed what to do, have we?

 

No, but we are talking about things you were previously considering, aren’t we?

 

You:  Indeed.

 

RULE 4:  SAVE THE RIGHT WAY

 

Okay then.  Next up are the better ideas to consider:

 

·  529 College Savings Plans

·  Educational Savings Plans

 

Note that there are two different kinds of 529 Plans: pre-paid tuition and savings. Separate from those are accounts simply known as Education Saving Plans that are not 529 plans. See the chart below:

 

 

 

	Education Savings Plan	529 Savings Plan	529 Pre-paid Tuition Plan
What is it?	Tax-advantaged plan invested for educational expenses	Tax-advantages plan invested for educational expenses	You pre-pay college expenses (tuition only) at today’s prices
Tax Treatment	No tax deduction, qualified withdrawals are tax-free.	No tax deduction, qualified withdrawals are tax-free.	No tax deduction, qualified withdrawals are tax-free.
Ownership	Parents	Parents	Parents
Contribution Limitations	$2,000 per year (Lower at high income levels.)	$12,000 per year (Legal strategies abound to contribute more if you want to and can afford it.)	$12,000 per year (Legal strategies abound to contribute more if you want to and can afford it.)
Drawbacks	Lower contribution limitations	Not so much.	Pre-paid element won’t necessarily apply.

.

 

Believe it or not, this is a simplified version. I’ve tried to be as clear as possible, but that means taking out some of the exceptions to the general rules. It’s always a good idea to check with the person assisting you with your account set-up to make sure that things will be as you expect for your specific facts and circumstances.

 

All three of these account types provide you with the following:

 

·  Your contributions, while not tax-deductible grow tax-deferred (aren’t taxed each year).

·  If the money is taken out for qualified educational expenses, the distributions are tax-free.

 

You: Tax-free?

 

Yes! That’s huge, because it basically means that you can save money for your child’s education and, as it grows, it is never taxed. Over many years, this can make a major difference in the amount you have available for college expenses.  As a result, any one of these plans is a far better option than, for example, a taxable account.

 

You: How do these plans work?

 

529 savings plans are operated by states. 529 pre-paid plans are operated by states and private schools. Nearly any brokerage house (Fidelity, Schwab, etc.) can help you set up an education savings plan.

 

You: Which one should I choose?

 

While everyone’s specific facts are different, I believe most people should most seriously consider the 529 savings plan, as it has the most advantages and the least disadvantages.

 

While an educational savings plan is a fine choice, you are subject to lower contribution limits.  You do retain flexibility for where your child goes to school, which is a nice feature.

 

The 529 pre-paid tuition plan has very high contribution limits and tax-free withdrawals when done appropriately. However, the pre-paid tuition plan may be restrictive if your kid doesn’t go to the “right” school.  In other words, it’s less flexible. The money you saved won’t be wasted, but it might not go as far as you had planned in the scenario where your child does not go to the school you funded through your plan selection.

 

The 529 savings plan has the most flexibility. It also has very high contribution limits and lets you keep control of the money—unlike a custodial account. Furthermore, you retain the ability to use the money at almost any college.  You receive all these benefits while retaining the all tax advantages featured in the other plans.

 

You: Should I pick the plan from the state I live in?

 

Maybe. In some states, choosing your own state’s plan can provide you with some state income tax advantages. It’s best to look that up on your own. Just go to your favorite search engine and enter the name of your state followed by the term “529 plan”

 

RULE 5:  INVEST YOUR SAVINGS APPROPRIATELY

 

Of course, once you get your money in the account, you must invest it. You have a long-term horizon for your two-year old child’s education right now.  As such, most of the money should be invested aggressively—in stocks.

 

You:  What if I don’t want to be making investing decisions for my child’s education?

 

Gary: No problem! I’ll do it. Remember those annuities we were talking about?

 

No, Gary, we’re not going there. 

 

You’ve got to invest this money for your child’s education. Don’t just leave it parked in cash or turn it over to Gary.  You can do this. Here’s some good news:  one of the advantages of many 529 plans is that the money can be invested appropriately for you. You tell them the age of the beneficiary (your child) and they invest it accordingly.  If your child is young, they invest it aggressively, then gradually less so as your child gets closer to beginning college.

 

You: That sounds pretty simple.

 

It is. You just need to take the first step; to start saving now for your child’s education.

 

You: But 2022, when my child enters college, is a long way away.

 

It is, but don’t delay.  While it’ll be some time before the cap and gown from your child’s high school graduation are tossed up in the air, those items come down from the sky much quicker. Will you be ready when they hit the ground, or will you be caught—napping?