The Money Class (8 page)

WHO SHOULD SAVE FOR COLLEGE?

Before you start to save one penny for a child’s future college costs, I insist that you have the following financial priorities taken care of:

• You do not have credit card debt.
  
• You have an eight-month emergency savings fund.
  
• You have a term life insurance policy.
  
• You are saving for retirement; aiming to set aside 15% of your gross salary.
  

Until all of that is in place you are not to think about saving for college. Many of you have heard me say this repeatedly over the years: There is financial aid for college. There are loans for college. But there is no aid or loans to help you in retirement. There is no aid if you run into a rough patch and you do not have sufficient funds in an emergency savings account to navigate your way out of trouble.

Your first order of business is building a solid financial foundation for your family. Only when that is in place can you begin to save for college. And know full well that there is absolutely no shame if you are not able to save. As I explain later in this chapter, there are affordable ways for your child to obtain a quality education. Trust me on this one: What your kids really need from you is the peace of mind that you have your own retirement plan in place so they will not be asked to support you later on.

THE BEST WAY TO SAVE FOR COLLEGE: 529 PLANS

If you have the ability to save for college, the best way to save is by setting aside money in a 529 college savings plan. The two big advantages of a 529 plan are a series of valuable tax breaks and the fact that just a small percentage of assets (less than 6%) inside your 529 account will be used by college financial aid offices when evaluating your family’s request for financial aid.

529 Plan Basics

A 529 plan allows anyone, regardless of their income, to contribute money into a special savings account that works much like an individual retirement account. There is no annual limit to what you can set aside; the lifetime savings limit is typically $300,000. You choose the investments for the account, and while the money is invested in the 529 plan there is no tax bill. Withdrawals from the plan that are used to pay for “qualified” school expenses will be tax-free. Depending on the state you live in and the specific plan you choose, you may also be able to claim some of your contribution as a deduction or credit on your state income tax return.

A 529 plan is, in my opinion, a better way to save for school than an UGMA/UTMA, a Coverdell Education Savings Account, or a Roth IRA.

UGMA/UTMA

These are custodial accounts that adults set up for minor children, as permitted by the Uniform Gifts to Minors and the Uniform Transfers to Minors acts. The child is in fact the “owner” of the account. There are tax benefits to these accounts, but I do not like them for college savings for two important reasons: Once a minor child reaches the age of 18–21 (depending on your state), he or she has complete control over the assets. If your child decides to take the money and head out for a global adventure, you have no legal right to stop her. The other problem is that UGMA and UTMA assets are treated differently than 529 assets when assessing your family’s application for financial aid. Less than 6% of assets held in a 529 plan owned by a parent (for the benefit of a child) are used to compute a family’s eligibility for aid. By comparison, 20% of assets owned by your child—such as an UGMA or UTMA—are factored into the calculation. In other words, money owned by a child will reduce your eligibility for financial aid, or the level of aid your family qualifies for.

COVERDELL EDUCATION SAVINGS ACCOUNT

There is nothing inherently wrong with a Coverdell (previously known as an Education IRA) but they don’t offer any major advantages over a 529. As with a 529, money you invest in a Coverdell grows tax-deferred and withdrawals will be tax-free if used for qualified education expenses. While there is no income test for making contributions to a 529 plan, married couples with income above $220,000 (or $110,000 for single tax filers) are ineligible to contribute to a Coverdell. Moreover, the current annual maximum contribution to a Coverdell—effective through 2012—is just $2,000.

ROTH IRA

It is absolutely true that a Roth IRA can be an interesting way to pay for college costs. No matter your age, money you originally contribute to a Roth IRA can always be withdrawn without penalty or tax. And if you withdraw any of the money you have contributed before age 59½ to pay for college costs, you will not owe the typical 10% early withdrawal penalty, though you will owe income tax on the earnings. (There are special rules for Roth conversion IRAs; see
this page
for details.)

The problem with using a Roth IRA to pay for college costs is that it can compromise your retirement planning. A Roth IRA should not be asked to do double duty: It cannot be a college fund
and
a retirement fund. If that’s your strategy you and I both know what is going to happen: Because college costs occur before retirement it is likely you will sharply reduce, if not use up entirely, the money in the account, leaving you high and dry for retirement. You need to resolve not to allow your retirement to be derailed by a competing demand that chronologically happens to occur first; chronologically is not how I want you to prioritize. As I explain in the class on retirement planning in your 20s and 30s, a Roth IRA is my favorite type of retirement account. I just want you to use it for retirement, first and foremost. Now, that said, if you have set up a Roth IRA with the explicit purpose of using it for college costs, that is a different matter. In that instance using your original contributions to the Roth to pay for school—they are not taxed nor do you owe any early withdrawal penalty—is a fine strategy. Just remember to leave the earnings in the account and use that for your retirement. If you were to make an early withdrawal of earnings from a Roth you might be hit with tax.

But please stand in your truth. If you know deep down that the Roth IRA you have is needed first and foremost for your retirement, please do not use it for college.

WHAT IF YOUR CHILD DOESN’T NEED THE 529 MONEY?

There are some important rules you need to understand in the event your child chooses not to go to college or is awarded so much in grants and scholarships that you don’t need all the money you have set aside in a 529 plan.

You can transfer the account to another beneficiary
. Most 529 plans allow you to switch a beneficiary to another family member, including siblings (and step-siblings), nieces, nephews, first cousins, and in-laws. You could also name yourself the beneficiary and use the money to go back to school.

You can withdraw the money for noneducational purposes
. There is no penalty or tax on money you contributed to the account, but if you withdraw earnings from the account and that money is not used for education purposes, it will be subject to income tax as well as a 10% penalty.

HOW TO CHOOSE THE BEST 529 PLAN FOR YOUR FAMILY

There are two flavors of 529 plans: direct sold and advisor sold. I only want you to consider direct-sold plans. The fees for advisor-sold 529 plans are too high, and often the advisor-sold lineup of investment choices does not include low-cost index funds. If you want the advice of a trusted financial advisor on how to handle your college savings, pay the advisor a separate flat fee for his work rather than have him guide you into expensive advisor-sold 529 funds. If your advisor only uses advisor-sold 529 funds I recommend you find a new advisor who is not dependent on commissions. At
NAPFA.org
you can search for local advisors who work on an hourly or fee basis.

TIP:
I highly recommend every family spend some time at
Savingforcollege.com
. It has wonderful articles and tools to help you make an educated decision about the best 529 plan for your family. Here are some important issues to consider:

Compare your state plan to an out-of-state plan
. Every state offers its own 529 savings plan. But please understand that you are not obligated or required to stick with a plan offered by your state. You can in fact invest in any plan from any state and use your money to attend any school in any state. The sole advantage of sticking with your state’s plan is if it offers valuable tax breaks or other incentives to residents. For example, contributions you make to any 529 plan are not eligible for a federal tax deduction. But some states allow in-state residents to claim a state tax deduction or a credit on their contributions. That said, there is often a limit on the value of the tax break, and in some states there is an income cutoff to be eligible for the tax break.

At
Savingforcollege.com
you can find state-by-state information on the tax treatment for in-state residents. This is obviously an important consideration when choosing a 529 plan, but it should not be your only consideration. It makes absolutely no sense to sign up for an in-state plan that has high fees and expensive mutual funds. It can make more sense to pass up the tax breaks and choose a plan offered by another state that has lower fees and better investment choices.

Focus on fees
. Similar to how a 401(k) works, when you contribute to a 529 plan you will choose from a menu of investment options. Typically these are mutual funds. Every mutual fund has an embedded annual fee called the expense ratio. This can be as little as 0.20% or so, or it can be 1.5% or more. The more you pay in fees the less your money will go toward paying for college. Before you sign up for a 529 plan make sure it offers mutual funds with annual expense ratios below 1%, and the lower the better.

Check for conservative investment choices
. As I explain below, by the time your child is a senior in high school you will want to have the bulk of your account in conservative investments; it is too risky to have your money invested in stocks when you know you will need that money in one to five years. Not all 529 plans offer a money market or certificate of deposit (CD) option. Please stick with a plan that gives you the option of pulling out of stocks as your child nears college age.

Understand beneficiary transfer rules
. If you have more than one child and you anticipate you may want to transfer the beneficiary from one child to another, make sure your plan allows this move.

HOW TO INVEST YOUR 529 PLAN

Many parents with children in high school learned a very painful lesson during the 2008 financial crisis when their 529 accounts lost 30% or more because so much of their account was still invested in stocks. Given that they had just a year or two before they would need to start tapping their funds to pay the college bills, they should never have left so much in volatile stocks. And what was most alarming was that many of these parents had left it to the plan to make the decision about how much to have in stocks versus bonds and other conservative investments. A popular feature of many 529 plans is an age-based fund that leaves it to the plan sponsor to alter the mix of stocks and bonds based on the child’s age. This works just like a target retirement fund; the idea is that as the child gets closer to college, the portfolio will become more conservative. In fact that’s how many plans work, but not all. The bottom line is that you cannot blindly rely on anyone to make your investment choices for you. You are responsible for making sure your money is invested in a way that makes sense for you.

If you investigate an age-based fund within a 529 and are comfortable with how it ratchets down your stock allocation as your child progresses through high school, then that is fine. But please make an informed choice. You can always build your own portfolio by choosing from among the other investment choices offered within the 529 plan.

Here is my suggested allocation:

• Under age 14:
  80–100% stock mutual funds
  
• Age 14:
  75% stock funds
  
• Age 15:
  50% stock funds
  
• Age 16:
  25% stock funds
  
• Age 17:
  0% stock funds
  

TIP:
One absurd restriction imposed on 529 investors is that you are only allowed to change your asset allocation once a year. Please be aware of this rule and make sure you complete all your rebalancing at one time.

If you do not choose the age-based all-in-one fund offered within the 529 (on
this page
I explain why I do not like these all-in-one funds), then the advice on investing your 529 echoes the advice in the retirement chapters: The bulk of your stock allocation—I recommend 85%—belongs in large U.S. blue-chip firms. If you see a fund with the words “S&P 500 index,” that is a good choice. Or any fund that is described as investing mostly in “large cap” stocks. The remainder of your stock allocation can be invested in an international stock fund or ETFs. We live in a global economy; while your U.S. blue chips typically derive plenty of their business from foreign markets, it’s also smart to have a small portion of your stock portfolio directly invested in an international fund.

For the portion of your portfolio not invested in stock funds, I recommend you stick with the cash or CD option within your 529. As I explain in the Retirement Classes, I have never liked bond funds. And with my expectation that in the coming years interest rates will rise from their current historic lows, bond funds will face especially rough headwinds.

THE COLLEGE TALK EVERY PARENT MUST HAVE WITH A HIGH SCHOOL FRESHMAN

As a family you need to start talking about college finances no later than freshman year in high school and begin to map out a strategy that will make college affordable.

Explain what you expect to be able to contribute to annual costs
. Your child deserves to understand exactly what, if anything, you will be able to contribute to his four years of college costs. Waiting until senior year to spring the news that you have little or nothing is unfair. By having the conversation earlier you give your child the opportunity to plan.