Saving for College: A Starter Guide

Photo by Rebecca Alison

Photo by Rebecca Alison

When it comes to saving for college, there are five important questions: How much should I save? On what schedule? In which kind of plan? Which state’s 529 plan? What underlying investments should I pick?

You likely already know how important it is to save for your kids’ college education. You may have already started the process. If you have a newborn daughter, you’ll need roughly $490,000 to pay for her engineering degree at Stanford or $240,000 for a poli sci degree at UCLA, assuming higher education costs increase by 4 percent a year.

Multiply that by two or three to take into account your other (future) children, and the amount seems pretty overwhelming. Here are some clear answers about how to reach your goal:

• If you can afford to invest a lump sum, research and the magic of compounding suggest it’s better to begin with a large amount than to invest regularly over a long period of time. (But talk to your accountant to ensure you don’t trigger gift tax problems.)

• A 529 plan is the best college savings vehicle for most people because of its tax advantages and the flexible rules that govern how your child can spend the money.

• If you are a California resident, the 529 plan sponsored by Nevada and run by Vanguard is a good option. (Continue reading to see why Californians should invest in a plan sponsored by Nevada and run by a national investment company.)

You can take those three valuable insights and walk away now. If you want to better understand college savings funds, read on.

How much should I save and on what schedule?

You have three choices: Put aside a lump sum, save a monthly amount, or do some combination of the previous two. This chart will give you a sense of the different results of the two approaches. It assumes your child won’t get financial aid. You can also play around with the costs of other colleges using this calculator.

Whether you begin with a lump sum or a monthly savings discipline, the accounts will start increasing significantly after a few years, barring a major slump in the market. In theory, if you begin with a lump sum, the amount will grow faster because you will have more years to compound. Also, markets generally trend upward over time. So if you invest in a diversified portfolio to improve your risk-adjusted returns and you have enough time to ride out the ups and downs in the market, the money that you put in earlier will multiply faster over the longer time period.

The Future Amount Required is calculated by taking this year’s tuition, room and board and applying the 4 percent annual higher education inflation rate. The Lump Sum Required Now is the amount you’d need to invest this year, assuming 6 percent investment returns, to meet the Future Amount Required at matriculation. This compares to the Monthly Savings Required if you can’t invest via lump sum and instead contribute the same amount every month to meet the goal.

What kind of plan?

The problem with this analysis is that it does not take taxes into account. The good news is that federal and state governments offer significant tax breaks for saving for your children’s education. The bad news is that the tax breaks are complicated and vary depending on which type of account you use and in which state you live.

First, a little background on the gift tax rules: You and your spouse can each give $13,000 to each child annually with no tax consequences. That amount increases periodically based on inflation adjustments. You may count any amount you gift above $13,000 annually against your lifetime gift tax exclusion of $5,120,000.

As an aside, if you are wealthy enough, you can simply pay your daughter’s tuition, room and board directly to Stanford or UCLA. Those amounts do not count as gifts.

Most people find that it makes sense to take advantage of one of the three investment vehicles outlined below.

529 Plan

The best plan for college savings is almost always the 529 plan because of its great tax benefits and relative flexibility. You put money into investments within the plan; the money grows tax-free; and when your daughter is ready for school, you sell the investments, and she uses the money to pay for tuition, fees, books and room and board—even computers and software. If she doesn’t go to college or doesn’t want to use the money for one of the other educational purposes that is permitted, she will owe taxes on the earnings plus a 10 percent penalty when the money is withdrawn.

There are two kinds of 529s: prepaid tuition plans and college savings plans. Prepaid tuition plans require you to use the money for a specific institution or institutions in a specific state. (If you’re certain your daughter will attend college in Virginia, then by all means go ahead and use a prepaid tuition plan from that state.)

The money in a college savings plan can be used at any institution, in any state—no matter which state sponsors the plan. The Securities and Exchange Commission offers a good primer on 529s here.

Some states also offer a state income tax deduction but usually only if you contribute money to a plan sponsored by that state. Some states cap the size of 529s. So if your daughter’s plan grows to $320,000, Texas, for instance, won’t allow you to make further contributions though the plan may continue to grow.

One final note: 529s have a special tax feature to allow lump sum investing. You and your spouse can each invest five times the annual gift tax limit of $13,000 (or a total of $130,000) but must file a gift tax return to treat this as a gift over five years. You can also apply the excess over your combined annual gift amount against your lifetime gift allowance ($130,000 – 2 x $13,000 = 104,000).

Coverdell Education Savings Account (ESA)

Coverdell ESAs, like 529s, can only be used for qualified tuition expenses. They offer tax advantages where your income and capital gains accumulate tax free and can be used for qualified education expenses (i.e., tuition, fees, books, and room and board) when your child goes to college. Coverdell ESAs are generally inferior to 529s because they have much lower contribution limits ($2,000 a year). You can’t contribute at all if your income is too high; your ability to contribute phases out at about $200,000 for a married couple filing jointly. The earnings are subject to tax and a penalty if the money is used for something other than educational expenses.

Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA)

The UGMA and UTMA both provide you with a fairly straightforward way to transfer assets to your children. These accounts provide flexibility because they can be used for any purpose, not just educational expenses. The assets in them do not grow tax free, but because the UGMA or UTMA account is in your child’s name, the earnings probably will be taxed at a lower rate though you should confirm with your accountant.

Three downsides to these accounts are that they are irrevocable so children can do whatever they want with them when the account legally becomes theirs (typically 18); they are included in federal student aid calculations; and income on the accounts is subject to annual taxes. The benefits of these accounts are that they are flexible (e.g., your child could use the funds for a down payment on a home one day) and easy to open.

Which state’s 529 plan?

Assuming you’re going with a 529, you next must decide which state plan to use. This Morningstar site includes information on 529 plans from the 50 states.

You’ll want to consider three factors when making the decision: whether your state offers an income tax deduction, what the plan’s fees are and what the underlying investments are.

Income tax deduction

California, unfortunately, does not offer a tax deduction. Californians who want to save with a 529 are free to survey the nation for the best combination of fees and investment choices. Or consider the rationale below for choosing the Vanguard plan through the state of Nevada.

Fees

529 plans are either sold directly to the public or through brokers or investment advisors. Those sold through brokers or investment advisors have higher fees. There are two kinds of fees on a 529 plan:

• Administrative fees. States or the financial services firms hired by the states to provide the investments charge these.

•  Fees on the underlying investments. These could be commissions (loads) and distribution fees, which are similar to 12b-1 fees used by mutual funds.

For Californians, the Vanguard 529 College Savings Plan provided direct from Vanguard and sponsored by Nevada is a good one. It has a minimum initial investment of $3,000 and a contribution limit of $370,000. It charges no enrollment, transfer or commission fees though it has a $20 maintenance fee on balances below $3,000.

What underlying investments should I pick?

A broker or advisor may try to steer you into actively managed mutual funds. Steer clear. Research shows actively managed funds are a bad proposition inside or outside a 529. On average, equity index funds outperform comparable mutual funds by 2.1 percent per year, primarily because of the mutual funds’ high fees.

Instead, look for index funds and other low-cost, passively managed plans. Within the Vanguard plan, you’ll find 22 investment options, all managed by Vanguard: three age-based options that automatically adjust to reduce risk as your child gets closer to college and 19 portfolios that have allocations to stocks, bonds and cash in varying proportions. The fees are low, ranging from 0.25 percent to 0.55 percent, depending on the investment option.

The age-based portfolios are constructed like target date retirement funds in that they reduce exposure to stocks over time as the drawdown period approaches. You’ll start out with a mix of asset classes based on your child’s age. The younger the child, the higher the allocation to stocks. As your child gets older, the fund automatically adjusts so that when your daughter is, say, 16, the portfolio will be weighted toward bonds and cash.

In other words, your portfolio is automatically rebalanced and reduces investment risk over time.

In contrast, the 19 portfolios are do-it-yourself options. You’ll be responsible for managing the investment mix to reduce the risk as college grows closer for your child.

The argument for investing in the portfolios that offer you more control is they could be used as a vehicle for investing for more than one generation or family member. (A 529 plan may only be transferred tax free from one family member to another. Check out this IRS information if you’re interested.) In the Vanguard direct plan, you could assemble the risk allocations to meet your needs. For example, you could mix the Vanguard Aggressive Growth fund, which is 100 percent stocks (U.S. and foreign) equally with the Vanguard Growth fund, which is 75 percent stocks and 25 percent bonds to get a portfolio that is 87.5 percent stocks and 12.5 percent bonds. This would be suitable for multiple generations of education. Note that this approach only makes sense if you anticipate exceeding your kid’s college tuition costs and plan to invest extra towards your grand-children’s college education.

The Bottom Line

Saving money toward a college education fund is one of the best gifts you can give your children. Start now. Keep one eye on the tax rules, and choose your investments to minimize the fees and maximize the risk-adjusted return. You and your children will be on your way.

Jeff Rosenberger is vice president of investment research at Wealthfront, a software-based financial advisor in Palo Alto.

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