Sunday, May 31, 2015

Investing for our child’s college education

Meet our future college graduate!
How will you pay for college?
With the upcoming birth of our son, we have been doing more preparation for his future.  The one thing that immediately came to mind was saving for college.  It’s hard to imagine preparing for an expense so far into the future.  How much will college expenses cost in 18 years?  Will it cost $100,000, $200,000, or more to send our child to a 4-year in-state public university?  What if our son wants to go to a more expensive private university? 

I hear parents joke about how their child is going to “just get a scholarship” or depend fully on student loans and government aid.  Parents have shared with me that they want to help pay for their child’s higher education expenses… but will start saving later.  I’ve been really surprised at how many parents take a “I’ll worry about college later” approach to planning.   

I imagine that most parents get overwhelmed when they think about how they are going to save enough to pay for their child’s college.  If you’re living paycheck to paycheck, how can you possibly consider setting money aside now to pay for college in the future? 

529 savings plans
I’m not going to debate the merits of a college education here.  We want to be able to give our son the gift of a college education.  We do not want our son crippled with college debt because we failed to plan for his future when we had the chance.  This is where investing in a 529 savings plan can help us fund our child’s college expenses.

A 529 savings plan is a type of investment account that is meant to be used towards college and other higher education costs.  The most useful feature of a 529 is the tax benefit it offers.  Many states let you deduct some of your 529 contributions (up to the state’s limit) on your state income tax return.  This means that you can get a higher balance in your 529 and lower your state income tax at the same time!  All earnings in your 529 are deferred from federal and state taxes.  Any money you withdraw from your 529 will not be taxed as long as the withdrawals qualify as higher-education expenses. 

Since we live in California, we do not get a tax benefit towards contributions into a 529.  However we still can benefit from tax deferred growth and tax-free withdrawals.  100% of your earnings are tax-free when used for college or higher education.  This beats using money in a taxable (savings or investment) account to pay for college.  Whenever the government offers a tax deduction, take it.     

Take care of your own retirement needs before your child’s college
If you’re living with credit card debt, the first thing you need to do is get rid of it.  If you have not started contributing to your own future retirement, you need to plan out your future first.  I recommend taking care of your own emergency fund savings (3 to 6 months of expenses) and retirement contributions (max out IRA and 401K) prior to investing in a 529 plan.  You can always get a student loan to fund college.  You cannot get a loan to fund your own retirement.  With the dismal savings rate of average Americans, I’m not surprised that up to 97% of people don’t use a 529 plan.

Money in a 529 will count as a parental asset when calculating financial aid.  On the other hand, retirement assets don’t count.  This is another reason why you should take care of your own retirement future first. 

Which 529 should you choose?
529 plans are state sponsored, and every state has their own program.  You can save and contribute towards ANY state’s 529 plan, regardless of which state your child is going to attend higher education.  California has a pretty good 529 plan, but so does Utah, New York, and Ohio.  See here for a guide on the best 529 plans in the nation.  Funds from a 529 plan can be used at any college in the country (including colleges, universities, trade or technical schools) for any qualified college expense (including books, room & board, fees)

We decided to sign up with the Vanguard 529 plan, which is sponsored by New York.  They have one of the lowest fees (0.19% expense ratio) compared to other states.  Vanguard does not charge you any transaction fees, account service fees, 12b-1 fees, or redemption fees.  Just like investing in your own retirement, fees can really wipe out your profits and tax savings.  The best part of the Vanguard plan (in my opinion), is one simple login for my IRA, taxable, and now 529 accounts. 

Vanguard also offers a 529 sponsored by Iowa, but the fees are slightly higher (0.26%).  The minimum to open a Vanguard 529 with the New York plan is $3,000.  The minimum to open a Vanguard 529 with the Iowa plan is $25.  We went with the New York sponsored plan for the cheaper expense ratio.  Setting up 529 at Vanguard only took 5 minutes.
What can you invest in with a 529?
Most 529 plans allow you to choose various stock, bond, and international index options.  You can choose to be as aggressive or conservative as you’d like.  A fund with higher risks may increase the potential for your portfolio to provide greater returns.  A fund with less risk may have fewer fluctuations in account value, but may provide less return.  For those who are risk adverse, the Colorado 529 offers a stable value fund with higher guaranteed returns (currently at 3.09%).  

The easiest option is an all-in-one age based portfolio that automatically changes its asset allocation and rebalances to be more conservative the closer your child gets to college.  Like investing in your future retirement, compounding growth works best the earlier you get started investing for your child’s college expenses.  Most 529 plans have limited reallocation of your fund selection.  I know Vanguard allows you to change your fund only two times a year.  Decide on a fund and stick to it.   

For now, the money in our 529 is in short term reserves.  Vanguard calculates age based options based on the date of birth of the beneficiary (child).  Once our son is born and gets a social security number, we will change the beneficiary information and invest in the Vanguard Aggressive Growth Portfolio.  This fund has one of the lowest expense ratios (0.19%).  Since inception in 2002, the fund has returned an average of 8.91% per year.

Over an 18-year duration, there has never been a negative return in the market.  Of course, past performance does not guarantee future returns.  All investments are subject to risk, and you could lose money. 

How much will we need to save up for college?
According to, the current average cost of a public 4-year in state college is $23,410 per year while the average cost of a private 4-year college is $46,272.  These prices include tuition, room, board, books, supplies, transportation and other expenses. 

I used this college cost calculator to determine how much we would need to save to cover 100% of a projected in-state public college cost of $178,059.   This calculator assumes that college costs will continue to increase 3% per year, with a conservative 6% earnings rate of our 529.  According to the calculator, we will need to make monthly contributions of $400 to meet that goal. 

Ideally, we would like our son to come up with his own money to cover some of his college expenses.  Having some “skin in the game” may keep our son motivated to succeed.  I disagree with parents that do not allow their children to work part time for income, insisting that their child should focus only on their academics.  Working part time at a young age before and during college will help your child learn responsibility and social skills.      

If our child pursues education beyond college, and there is still money from his 529, remaining funds can help contribute towards those expenses.  The 529 can also be transferred to another child at anytime. 

With our high savings rate, I am not too worried about covering our son’s college tuition (as well as our retirement needs).  18 years from now, we should be financially free from full time work.  If we do work, hopefully it will only be part time in careers that we love.  Our mortgage should be paid off within 17 years, which should free up a good chunk of monthly cash flow. 

What if you need access to the money in your 529?
Nonqualified withdrawals from a 529 are subject to federal income tax, a 10% federal penalty tax, as well as state and local income taxes.  The 529 is designed to be used for higher education expenses, NOT frivolous purchases.  No matter how prepared you are, emergencies can still happen.  While you may have to give up some of your earnings if you make a nonqualified withdrawal, you won’t pay a penalty on the amount of money you’ve contributed.

If your child receives a scholarship, that amount of money can be withdrawn from a 529 without penalty.

Bottom line
If your child is going to college, someone is going to have to pay for it.  Your child may get a scholarship.  Your child may take a high interest student loan.  Your child may have to work for a program that offers loan forgiveness.  If you want to help pay for some or all of your child’s college expenses, funding a 529 plan is the most tax efficient way to do it.

Like most investments: the earlier you get started, the more your money has the opportunity to grow.  I’m glad we got started.      

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