According to a recent College Board study, the average cost of tuition, fees, room and board for state public colleges in 2020-2021 is $ 26,820 per year and $ 54,880 for a four-year private college. For a child born today, the cost of a four-year college education is expected to be $ 526,629 for the private sector and $ 230,069 for the public, according to a recent study by JP Morgan. Imagine if you have two or three children?
Of course, there are financial aid, merit scholarships and sports scholarships. Most schools reduce the price of the sticker. But there is no guarantee that your child will receive help, so we have to plan. Unfortunately, I find that most parents don’t have a college savings plan. Parents have good intentions and take care of their children, but for some reason they never manage to put anything in place. Parents who say they “have a plan” are often just throwing money aimlessly into a 529-year-old age-based education savings program. It’s a good start, but not enough to cover the university’s future six-figure costs. Planning for the astronomical cost of college requires more. It requires a thoughtful and meticulous plan.
For my clients, we start by reviewing their goals and objectives. We look at the expected cost of public and private colleges in their home state. Then parents can decide to try to cover 100% of the tuition, 50% or maybe a third. Having a goal in mind is extremely important. It creates motivation and decreases anxiety. We then look at their monthly cash flow to find an amount they feel comfortable allocating to an education savings program. From there, we build a holistic plan. We review their employer’s plans, such as deferred compensation or company stock plans, insurance needs and expenses, discuss retirement savings, inheritances and anything else important for conversation. We then review several college savings recommendations.
Here is one: Forget about age-based options.
You are probably familiar with the 529 Education Savings Plan. These programs are a solid choice for college savers. Contributions are after-tax (no upfront federal tax deduction), income grows with a tax deferral, and withdrawals for qualifying higher education expenses (room, board, tuition, and some fees) are free tax. In addition, the assets of a 529 plan receive preferential financial assistance when they belong to a parent. A maximum of 5.64% of parental assets counts towards a family’s expected family contribution (EFC) when applying for federal financial aid, compared to 20% of a student’s assets (Source: Savingforcollege.com) . There are penalties for not using 529 college money, namely a 10% penalty on withdrawals, and earnings are taxable on income.
Many parents are familiar with the 529, but many do not make full use of the program. In practice, I find parents contributing $ 529 monthly to an age-based mutual fund. At first glance, this seems logical. An age-based mutual fund invests in more aggressive stock mutual funds for young children, and then automatically switches to more conservative bonds as the child ages and moves closer to college. This makes sense because you want the 529 money to be careful as the kid gets closer to withdrawing the money for college. Age-specific funds are a make-and-forget choice, meaning busy parents don’t have to manage the investments themselves.
Personally, I don’t like the age-based options.
Age-based mutual funds are mostly too conservative. For example, Vanguard’s 529 age mutual funds have bonds for all ages, starting at age zero! This means that a newborn, at 18 years of age needing money for college, has conservative, low-yielding obligations in the account. Fidelity’s Connecticut Higher Education Trust (CHET) age-based option 529 for an 18-year-old college child – the 2039 portfolio – has 5% in bonds. The 2036 portfolio – for a 15-year-old college kid – has 14% bonds.
This is a huge mistake, in my opinion. The ties are too conservative for such a young child. I understand the importance of asset allocation, having been in the company for 20 years. I use bonds to diversify portfolios and think bonds play an important role in helping a portfolio weather a market storm, as bonds generally hold up better in a market crash. But I also understand that a newborn baby has a lot of time before needing money to go to college. 18 years from now, the child’s account will experience many market corrections, ups and downs. I’m not so concerned about a drop in the stock market with such a young child. I’m more concerned with the skyrocketing costs of college, otherwise known as inflation.
Forbes recently reported that the cost of attending college has increased more than twice as fast as inflation. More than twice as fast as inflation! Costs increased 497% from 1985 to 2018. Good luck beating that inflation rate with low yielding bonds.
Inflation is the real risk for a newborn baby, not a market correction when the child is 5 years old. Not only that, but if interest rates rise, bond prices can fall, making bonds in some ways riskier than stocks.
My advice: Forget about age-based 529 options and choose the funds yourself, depending on your time horizon of needing college money. Children over five to seven years of age may want to consider an all-equity portfolio to maximize their growth. With the high cost of a college education, you’ll need all the growth you can get from your investments.
If you still want a fixed income in your 529 plan, you should be asking yourself: what’s the best approach? Does a bond index make sense? Probably not in this low interest rate environment. A bond index holds both short and long term obligations. Long-term bonds are more sensitive to interest rates, which means that if rates go up, your principal will likely go down. You should check if your 529 plan offers an active fixed income manager to provide investment flexibility. An active fixed income manager may have higher fees than an index, but can better manage the fund for performance and adjust holdings if interest rates rise. Some 529 accounts offer a “stable value” option, which may be less profitable, but offers better capital protection than a bond fund.
Start by reviewing your home state’s 529 plan versus an out-of-state 529 plan. Does your state offer tax relief for contributions to its 529 plan? Even so, how does the fee compare to your home state’s 529 versus another state’s plan? You can use a 529 plan in other states. Some states, including California and New Jersey, do not offer tax relief for contributions. Either way, you need to compare the fees and mutual fund options in your state’s plan versus an out-of-state 529. Just because a state offers a state tax deduction for your contributions does not mean that it is a “good plan”. Plus, the state tax deduction usually doesn’t amount to much either. 529 plans in other states may offer lower fees or a better selection of mutual funds.
I love 529 Education Savings Plans and I have three accounts of my own, one for each of my three children. But when it comes to choosing a 529 plan and choosing the right mix of investments, I encourage parents to use a little more discretion. A little effort today to pick the right 529 plan or manage investment choices can literally pay bigger dividends for your child in the future.
This article is the first in a three-part series on how to save money for college. Next month, I’ll take a look at how to take advantage of the one-time tax break from a custody account. In the meantime, if you’re looking for a more thoughtful approach to saving for your child’s education, feel free to visit my website and schedule a free college savings assessment.