When it comes to saving and investing for college for your children, there are really three different questions to answer:
- What asset classes should you invest in?
- What kind of account should you use?
- In whose name should the account be?
First Things First
The first step is to define your objective: how much are you going to need, when will you need it, and for how long? You can start by determining how much a college education is going to cost.
But no sooner than you estimate the total cost of a college education, you encounter a more difficult issue: of that total cost, how much can you reasonably be expected to pay out of your own pocket? That is going to depend on a number of variables that may be difficult to define, including:
- How much might your child receive in scholarships?
- What will your family income be?
- How much in usable (i.e., non-retirement) savings will you and your child have accumulated?
- How many other children will you be sending to college?
The closer you are to the date your student starts college, the easier these questions are to answer. Yet on the other hand, the sooner you begin planning - while answering those questions might be more difficult - the better off you'll be when your child is ready to take that next step.
In part, how much you actually put away for your children's college educations will be a function of how much of what you earn you can afford to put aside - after meeting all your bills and putting the right amount aside for other long-range goals, like your retirement.
In thinking about how much you might receive in need-based aid, if you are already in a high tax bracket, it's safest to assume that you won't get much help. And the younger your child is, the safer it is to assume that he/she won't qualify for a scholarship (if he/she does, even better - but at least you're not relying on it).
Longer Time Frames Suggest Greater Risk Pays
If the child you're planning for is eight years or younger - meaning there's at least 10 years before he/she matriculates - stocks should definitely be part of your investment mix. Given that college costs have risen on average about 6% a year for the last 25 years, it makes sense to try to get at least that long-term compound rate of return. But that will probably only be possible if stocks make up a significant portion of your education portfolio mix.
As with any portfolio, as you get closer to the date you need to begin spending the funds, the more conservative you should become by shifting assets from stocks to bonds and/or cash.
What Type of Account?
The basic choices are a taxable account and a tax-advantaged section 529 account. Section 529 accounts are funded with after-tax contributions but grow tax deferred, and all withdrawals for legitimate education expenses are tax free. Unless you are investing in tax-free bonds, the tax advantages of a section 529 account are considerable.
There is always the risk that your child won't go to college or that not all of the assets in the section 529 account will be used. In that case, the beneficiary can be changed to any close relative, including yourself, your spouse, other children, grandchildren, or other "close relatives" without penalty.
All 50 states and the District of Colombia sponsor section 529 plans, and many of them offer different features, including types of investment options and expense ratios. It pays to shop around, because by law, you can invest in plans sponsored in other jurisdictions.
Another issue is whether to take advantage of some section 529 plans' option to prepay college expenses at locked-in prices. This requires caution, as the plans aren't backed by federal guarantees, and with recent poor investment results and continued college inflation, it is important to ensure that the plan won't run out of funds before you tap into your account.
In Whose Name?
Before the advent of section 529 plans in 1996, parents and grandparents typically opened UGMA (Uniform Gifts to Minors) or UTMA (Uniform Transfers to Minors) accounts. Compared to section 529 accounts, these have several disadvantages: they are subject to income and capital gains taxes (although at the minor's rates), and the assets revert to the child's control once he/she reaches the age of majority. If funds remain at that time and the child hasn't completed college, there's no way to control how the child spends the funds.
Apart from that consideration, however, is another: since these kinds of accounts are held in the child's name, 20% of the assets will be considered available by financial aid officials for covering college expenses. In contrast, just 5.6% of non-retirement assets held in the name of a parent are considered available to pay for college.
Please call if you'd like help saving and investing for your child's college education.