How Should I Save for College

in Financial Planning-RSS, Personal Finance Essentials by

If you have children, or are about to, it’s wise to begin planning for college education costs. The table below details average costs per year for college over the last decade for four year institutions:

2000 – 2001 2009 – 2010
Public Institutions $10,609 $14,870
Private Institutions $26,795 $32,475
All Institutions $15,843 $20,986

These figures do not include living expenses. That means the average cost for tuition, room and board has increased over 30% in the last decade. In other words, higher education isn’t cheap and planning ahead has become critical. But most don’t know even where to begin.

What are your options?
There are several account types you can use for saving, each with its own advantages. Some of the most common include:

  • 529 Plan
  • Roth IRA
  • Traditional IRA
  • Taxable account

The latter three options offer greater flexibility—you maintain full control over the underlying investments. This also means they require greater responsibility and may not be ideal for “hands off” investors. You would be in charge of monitoring and maintaining the portfolio allocation over time.

A Roth IRA may be best if you’re unsure your child will attend college or if you want to maintain monetary flexibility. With a Roth, you save after-tax dollars and the investments grow tax-free. You can then access principal and earnings for qualified educational expenses, with the principal tax-free. All of this makes the Roth IRA a great investment option, as long as you’re willing and/or capable of sacrificing its use as a retirement vehicle. There are also investment and income limits. The 2013 investment limit is $5,500 per individual, $6,500 if you’re over 50 years old. If you’re single, the full contribution is possible with adjusted gross income of $112,000 or less—this goes up to a combined $178,000 if married and filing jointly.

Traditional IRAs offer the same benefit of tax-deferred growth, and you can withdraw money penalty free for qualified educational expenses at any age. Unlike a Roth, however, you still need to pay income tax on the entire withdrawal.

Taxable accounts offer the greatest flexibility as there are no savings limits and you maintain full control over the underlying investments. Their primary drawback is a lack of any tax benefit.

The 529 plan has quickly become the most popular method of saving.

WHAT IS A 529 PLAN?
A 529 is generally a state-sponsored plan used specifically for college education savings. The benefit over a traditional taxable account is investment gains grow and can be withdrawn tax-free, similar to the Roth IRA (savings into the plan are also after-tax). Moreover, many states offer additional tax benefits to local residents who invest in their respective state’s plan. While there is no limit to annual contributions, there are lifetime limits that vary by state—they are typically very high (more than $200,000).

How do 529’s differ?
The differences in plans can be separated into two categories:

  • Tax Benefits
  • Plan Specifics

Tax Benefits
Tax benefits vary. States like Indiana offer an actual tax credit, while most other states offer an annual deduction on taxable income. Some states, such as California and Massachusetts, offer no tax benefits to local residents—in these cases there is no reason for residents to use an in-state plan unless it is superior to out-of-state plans.

Plan Specifics
The most important factors with respect to plan specifics are investment options and fees. Options refer to the underlying investments (e.g. mutual funds) available for purchase as well as the method they can be purchased. Most states offer two investment methods: static and age-based. Static implies purchasing funds individually. This shifts responsibility for monitoring the portfolio’s allocation to the investor. Age-based refers to pre-set investment tracks in which the allocation changes automatically (usually to a more conservative portfolio) as the beneficiary ages and nears college.
Fees vary significantly by plan and can be charged for enrollment applications, account maintenance, program management, and the expenses of underlying investments. Total annual fees range from 0.18% annually for the lowest cost plans to 1.85% annually for the highest cost plans. Some are only sold through financial advisors—these will typically carry higher fees relative to those available for direct purchase.

When does a 529 make sense?
529 plans are primarily geared towards investors fairly certain the beneficiary will attend college. Most plans offer valuable tax benefits and can be an attractive option for more “hands-off” investors (assuming an aged-based option is available). But there are tradeoffs. If fees are high, the tax benefits could begin to fade relative to purchasing low cost ETFs elsewhere. Investors looking for greater flexibility over investment choices might also find a 529 unattractive.

Every situation is unique, so there is no ‘one size fits all’ answer. If you have the means, funding a 529 with $30,000 to $40,000 up front is a good place to start. If you’re set on a private institution, it would require about $60,000. In other words, enough to cover about two years of college in today’s dollars.

There is some simple math behind these figures. Tuition costs have skyrocketed, but longer-term they’re more likely to resemble typical inflation at around 3%. That means you’ll need to earn a modest real return of approximately 4% (after backing out inflation) to double your investment over 18 years. This should allow you to roughly afford all four years by the time your child goes to college.

And if you can’t afford a large upfront investment, it’s okay to save a little at a time. Investing $250 per month over 18 years would give you roughly the same amount as a $30,000 upfront investment (assuming 7% annual growth). But remember, you don’t want to save too much. If the market has a strong run you may be left with excess funds you’re unable to access without a penalty.

What if our child doesn’t use it all?
If a child does not attend college, money can be transferred to another qualified beneficiary to be used for education. Qualified beneficiaries include immediate family members, relatives of your immediate family (e.g. nieces, uncles, etc.), in-laws, and first cousins. A 10% penalty and ordinary income tax are charged on investment gains for non-qualified distributions. There is no penalty or taxes on principal.

What are the best 529 plans?
There are many plans to choose from, and the best option can depend on your state of residence. Remember, tax credits and deductions are offered for many in-state plans. Here are some websites that can help in the selection process:

Assuming you’re not eligible for tax benefits, there are a few low-cost plans we believe are good choices.

Vanguard 529 College Savings Plan
Offered through the State of Nevada, there are no tax deductions for this plan. However, with annual fees as low as 0.25% it represents one of the cheapest options. And its 19 static and 3 age-based investment options give participants plenty of flexibility. There is a minimum initial investment of $3,000, and you can sign up entirely online by going to:
Vanguard 529 Plan

Utah Educational Savings Plan
This is another plan offering low-cost Vanguard index funds. With its 6 static and 4 age-based investment offerings, it is not as diverse as the Vanguard Nevada plan. But it makes up for it in fees which can be as low as 0.18% per year. It offers Utah residents tax deductions on income. There is no initial purchase minimum, and you can sign up online at uesp.org

The final impact?
Tax-free growth, such as that offered through a 529 or Roth IRA, can have a significant impact on final savings. Assume you invested an upfront amount of $30,000. At the end of 18 years, you’d have over $101,000 with a 529 plan, and about $86,000 in a traditional taxable account (after taxes on the withdrawal). That’s savings of over $15,000! This assumes 7% annual growth and a 15% tax rate.

Sources: Morningstar.com, Savingforcollege.com, Money Watch, Schwab.com, National Center for Education Statistics, IRS.gov, Personal Capital Research

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Brendan Erne, CFA
Brendan Erne serves as the Portfolio Management Team Leader with Personal Capital Advisors. He has over 15 years of industry experience, spanning almost all levels of the investment process, including several years at Fisher Investments as an equity analyst covering the Technology and Telecommunications sectors. He also co-managed a large cap growth portfolio and co-authored Fisher Investments on Technology, published by John Wiley & Sons. Brendan is a CFA charterholder.

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Disclaimer. This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data's currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.