There are a myriad of factors to consider, but one thing’s for sure--the earlier you start saving the better. Just don’t neglect your own retirement savings
By Robert J. Pyle, CFP®, CFA, AEP®
This is the time of year when high school seniors and their families are sweating out college acceptance letters. Study after study shows that a college degree is still worth it despite the skyrocketing costs. For starters, the pay gap between those with a four-year degree and those with a high school degree is at a record high according to the Bureau of Labor Statistics. Not only are college grads significantly less likely to be unemployed, but on average, they out-earn those without degrees by about $1 million in lifetime wages.
So, while a college education remains the American dream, it is becoming less and less affordable. An Edward Jones study found that only one in six Americans (17%) feel they can afford the cost of a college education for themselves or a family member. In fact, only one in three respondents who earned six-figure incomes felt they could afford the cost of college today.
College tuition at public universities has nearly quadrupled over the past 35 years. The reasons are too complex discuss in detail in this article. Among the leading reasons:
High increase in public subsidies for higher education
Sharp rise in percentage of Americans who go to college
Enormous expansion of the federal Pell grant program
Expansion of University administration. Large growth rate in administrative positions – 60% increase between 1993 and 2009.
Suffice it to say, attending college is a lot more expensive than it used to be in both real and inflation-adjusted terms. That’s why we build a 6-percent annual tuition increase into our clients’ college savings plan-- i.e. about 3% MORE than the historical rate of inflation.
The average cost of public four-year university is about $25,000 for in-state tuition, $41,000 for out of state tuition and $51,000 for a private university.
SCENARIO 1: If you earn an average of 5% per year on your college savings plan and college costs increase by 3%, you need to save the following annually:
SCENARIO 2: If you earn an average of 5% per year on your college savings plan and college costs increase by 6%, you need to save the following annually:
SCENARIO 3: If you earn an average of 5% per year and college costs increase by 5%, you need to save the following annually:
Also, many students and families neglect to account for all the “hidden fees” of college beyond tuition, room and board. These can include: Fraternity/sorority dues, clubs, trips, meals outside the cafeteria, and travel to and from school, especially if airfare is required.
How to close the saving gap
Most experts say a 529 plan is the best option for saving for a child’s or grandchild’s education.
The earnings generated in a 529 plan are not subject to federal income taxes, allowing the investments to grow without being depleted annually by taxes. Additionally, when the money is used for qualified education expenses, the distributions from the 529 plan are not subject to federal or state income taxes. Here are seven more key benefits of 529 plans.
What to look for in a 529 plan
For starters, you want low cost and good diversification options. The Colorado 529 Plan has Conservative Age Based, Moderate Age Based and Aggressive Age Based. For example, age 0-4 it’s 100% stocks in Aggressive vs. 87.5% stocks the Moderate and 62.5% stocks in the Conservative. Each portfolio becomes increasingly more conservative as the child/beneficiary gets older:
Also look at:
Past state performance
Relative investment fees
Any “in-state” advantages of establishing a 529 in your state of residency
You are free to invest in the 529 plan of any state, but the Colorado plan, checks off the boxes for most Colorado families. What’s more, in many states including Colorado, you will also get a state income tax deduction for contributions made to your in-state 529 plan. If you don’t get a deduction for investing in your own state’s plan, then we recommend the Utah Educational Savings Plan to many of our clients. Here is a helpful chart outlining state tax deductions by plan.
Why a 529 is better than UTMA
I sometimes get asked if The Uniform Trust to Minors Act (UTMA) is better than a 529 plan. There’s really no reason to go with an UTMA since it counts against your financial aid chances five times more than your 529 plan savings do. Since an UTMA is counted as an asset of the student, then 20% of the money is expected to be used versus 2.6% to 5.6% of the parent’s assets (including 529 plans owned by the parents). One way circumvent this rule is to transfer the UTMA assets to a 529 plan owned by the student and the asset is reported as a parental asset
Here’s another drawback to UTMA: Once a child is no longer a minor (age 21 in Colorado) he or she will take ownership of the account and can spend the money on anything they want, not necessarily for college. By contrast, a 529 account remains with the adult who set up the account and only withdrawals used for education purposes remain tax-free.
Should we start taking risk off the table as my son or daughter gets closer to college age?
In most cases yes, and the “glide path” for college savings is similar to the glide path you would follow for your retirement plan. As mentioned earlier, you want to maximize the account’s appreciation when your child is young and get increasingly conservative as you get closer to withdrawing from the account for college costs. Most plans allow you to do the reallocations yourself, but I recommend letting the plans do it for you—they’re the pros and they do this all day long.
Should we continue to fund a 529 plan after our student begins college?
Generally, I recommend that clients keep contributing to a 529 plan after their child has enrolled in college as long as they’re in a plan that provides a state tax deduction—in Colorado, it’s 4.625% of what you contribute each year. Plus, you will still earn some appreciation on your principal over the four-plus years that your child is enrolled.
Changing asset allocation based on market conditions
If the markets are going crazy when your child is young—i.e. when your account is likely to have a higher exposure to the stock market—it’s tempting to move into the safer fixed income options your plan may offer. I don’t recommend this approach. Essentially, you’re trying to be a “market timer” and it’s very difficult to know when to “get back in” to the higher growth options your fund offers. Not only do you risk missing out on significant market upside, but many 529 plans have strict limits on the number times you can make asset allocation changes each year. That being said, if the market takes a big drop, it might be a good time to add more money to your 529 plan. Why? Because you’re buying units at relatively low cost.
Asking grandparents for help
Many grandparents are at a point in life when they can make generous gifts to grandchildren, especially if the money is to be used for something as worthwhile as college tuition vs. just buying junior a new car. Just make sure the grandparents’ gift is put in the name of the student/beneficiary’s parents—not the grandparents. That’s because funds in the grandparents’ name are more likely to count against you if your child is applying for financial aid. A withdrawal from a 529 plan owned by a grandparent or other third party is required to be “added back” when reporting income on the FAFSA financial aid form. The amount of the distribution will reduce eligibility for need-based aid by as much as 50% of the amount of the distribution. It counts as untaxed income to the beneficiary.
Don’t count on athletic scholarships
According to this CBS Moneyline report, the odds of getting a scholarship is less than 2 percent and the average scholarship is less than $11,000. Playing high level college sports can still be fun, but just know that if your child or grandchild is among the lucky few to land an athletic scholarship, make sure they absolutely love their chosen sport. It will be at least a 40-hour per week commitment and competition for playing time is extremely fierce since nearly everyone on the roster was captain of their high school team and earned All-League/County/State, etc. honors. Not to be a dream dasher here, but think about all that money you are putting into your kids’ travel sports teams and private coaching. Suppose instead you invested those thousands of dollars a year in a 529 plan where it could compound for 10 to 15 years?
Retirement savings vs. college savings
One of the toughest challenges many of our clients face is finding the right balance between saving for their childrens’ education and saving for their retirement. If you have two children, the numbers can be overwhelming. If you are thinking about a private four-year college, the amount you need to save for two children is more than maxing out a 401(k) contribution for one person (($30,422 for two kids vs. $19,000 for a 401(k) under 50 or $25,000 over 50.))
There are no quick and easy answers, but we have tools to help our clients model many different scenarios. For instance: “If I save $X for retirement and $Y for my child’s education, is this going to get me to my goals for both?” Then we can look at alternative scenarios in which you save twice as much for your child and look at how much longer you would have to work. Is that acceptable to you and your spouse? That’s a tough balance for most people and requires careful consideration of your timeline, your goals and your aspirations for your children.
In a future article, I’ll discuss the importance of choosing employable majors, additional savings tactics, what to do with unused 529 after your children complete college and whether or not the cost of elite private schools is worth it.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail email@example.com.
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