Gain Confidence About Paying For Your Children's College Education
I am not worried about paying my sons' college tuition because my wife and I have a plan. The process I went through to gain confidence about this financial milestone took plenty of time, but the implementation it took me was less than 30 minutes. Thus, it should take you the time to read this blog post plus about 30 minutes to also cross paying for your kid’s college off your worry list.
The sooner we invest and the smarter we invest, the less we will need to contribute to fund our child’s hopes and dreams. Most importantly, they can focus on maximizing their human capital at any school they choose and not have to worry about student loans. The United States currently faces a student loan crisis. Over the past 11 years, student loan debt grew 157%, and now sits at $1.5 trillion, according to Bloomberg. Through prudent planning and investing, your children will not be a part of that figure. They will graduate debt free.
How much to save
To clarify the amorphous idea of paying for college at some date in the future, we will simplify our objective. We will endeavor to prepay our kid’s tuition as if they were enrolling in college now. Then, we will assume that investment returns will keep pace or exceed future tuition inflation. So how much does college cost today?
As an example, according to the University of California, Los Angeles, one year of school currently costs $35,000: $13,000 for tuition; $16,000 for housing; $1,500 for books and supplies; $2,000 in healthcare costs; and $2,500 in additional miscellaneous costs.
Therefore, if my family can set aside $140,000 for one child we can be as close to 100% confident as possible that we will be able to pay for four years of college education in full. Then, once a year we can update our expected cost of future education expense, which gets more accurate every year as the event approaches.
For those considering private or out of state education costs, Harvard’s all-in cost for one year of education is currently $68,000, while Stanford’s is similar at $69,000.
The Best Vehicle to Use
The best college savings instrument is a 529 plan. 529 plans are not federally tax deductible, but gains and qualifying distributions are not taxed. Thus, individuals can compound their college savings while avoiding the current long term capital gains rate of 15% (if your income is between $77,201 and $479,000 for a married couple filing taxes jointly).
$140,000 invested today would be worth $444,000 in 15 years assuming a compound annual growth rate of 8% inside of a 529 plan with no capital gains tax. The exact same investment inside a brokerage account, assuming the capital gains rate is still only 15% in 15 years, would be worth only $378,000 assuming no capital gains tax paid other than the one associated with using the money to pay for college.
However, the increased wealth would likely be much greater as savers can also avoid interim capital gains taxes, which allows you to shift your asset allocation over time without having to worry about paying capital gains taxes along the way. For example, as your child approaches college age, it will be prudent to shift more of the account from stocks to bonds. Inside a 529 account you can make this change without needing to factor in tax consequences. In a traditional brokerage account, you would have to weigh the benefits of making the correct investment decision against the cost of needing to pay capital gains tax. It is likely that setting up a 529 account today will save you more than $100K over time, per child.
Money inside a 529 can be used tax and penalty free to cover all relevant education expenses. Qualifying distributions include: tuition; books; housing; etc. As of 2018, 529 funds can also be used to partly pay for private school from kindergarten through high school.
The Best Plan Provider
There are three main considerations when choosing a 529 plan: 1) if the state you live in offers state tax deductions, 2) the plan’s available investment options, and 3) fund expense ratios.
A quirk of 529 plans is that they are tied to states, with California only offering one by TIAA-CFEF, for example. However, individuals are allowed to sign up for the 529 plan of any state.
The states that offer tax deductions for 529 contributions are highlighted in blue. If you live in a blue state you should look into the plan offered by your state and most likely select that one. Colorado, for example, allows the full deduction of any 529 contribution. While Washington DC allows up to $8,000 in deductions for married joint tax filers. A helpful link with information by state can be found on finaid.org.
Data source: FinAid, map by MKAM
I, like many of our readers, live in a grey state, California, that offers no state deduction. If you live in California, New Jersey, or any other state without state tax deductions, you can pick whatever state’s plan seems best to you. I chose and recommend the Vanguard plan officially offered in Nevada. The Vanguard Nevada plan offers a good mix of low cost (0.10% annual fee) index funds that you can select in any combination you want.
The Best Investments to Choose
Roger Ibbotson, professor of finance at Yale University, demonstrated that more than 90% of the variability of investment performance over time is attributable to asset allocation. In other words, the amounts you put into stocks versus bonds and in the USA versus the rest of world, will be the largest determining factor of the investment returns you generate.
10 years ago, in March of 2009, I told a group of fearful 30 year old's in San Francisco that it was a fabulous time to invest. At the time the S&P 500 had fallen from a high of 1,528 in October of 2007 to a low of below 800. As a result, the price-to-earnings ratio for the S&P 500 fell from 16 to 12, as measured by FactSet, during that span. While this was scary, this meant the market was on sale.
Today, the US stock market has fully recovered and more. As of today, the S&P 500 is priced at 2,810 and only a few percent off of it’s all time high. Further, the P/E ratio is back to 16.0, in line with it’s 5-year average, but above it’s ten year average of 14.7.
During this time, S&P 500 returns have been fantastic. In fact, as of today, the trailing ten-year total return for the S&P 500, including dividends, was 17% per year, well above the long-term historical average return of 10%.
At the same time, international stock returns have lagged materially. Over the past ten years the rest of the developed world, as measured by the MSCI All Country World ex US Index, returned 10% per year. Over the past five years, the same index has returned a paltry 3%.
This underperformance has led to stocks overseas being priced cheaper. While the P/E ratio of the domestic S&P 500 is over 16, the P/E of the MSCI All Country World Index is 12, or 25% less.
Over the long-term, stock returns have been remarkably similar across geography, as documented in “Triumph of the Optimists,” by Dimson, Marsh, and Staunton. It would be a wise bet to assume the rest of the world will catch up to the USA over the next decade. As a result, my recommended asset allocation is: 60% Vanguard FTSE All-World ex-US ETF (VEU) and 40% Vanguard Total Stock Market Index Fund (VTI).
What Happens to Excess Savings?
The most often cited reason I hear for not setting up a 529 plan is some variation of not knowing if you will need the money to pay for college and could have money left over. What if your child gets a scholarship? What if Lamda Schools totally revolutionizes how we offer education and it becomes dramatically cheaper? What if your kid becomes a programmer and does not need four years of school? These are legitimate questions and would frankly be awesome if they happen. But, as the saying by Dennis Waitley goes, “expect the best, plan for the worst, and prepare to be surprised.”
Uncertainty about your child’s future college plans or tuition costs should not keep you from contributing to a 529 plan. The key idea is that by prepaying for future college expenses now, you remove any risk and worry about not being able to afford a college education for your child or saddling them with onerous student debt.
If you have money left over after paying for undergraduate tuition you can: use the excess funds to pay for graduate school; change the beneficiary to a second child; or change the beneficiary to a grandchild and let the money grow perpetually tax free. Alternatively, if you have covered all of your future education expenses with the funds and still have money left over, congrats!
After paying a federal penalty of 10% and state penalty (if applicable, varies by state, California charges 2.5%) on the gains, you can use the extra money for non-education purposes. You have to pay income taxes on the gains as well, but that is no different than if you saved outside of a 529 account. The benefit of compounding tax free, in my case for 16 years, outweighs any future penalty on unused funds.
After you have contributed the maximum to your 401k or IRA there really is no good reason not to take advantage of the tax benefits of a 529 plan if you have children.
Important 529 Facts
· Individuals should maximize their 401k or IRA contributions before contributing to a 529 plan as those contributions are federally and state tax deductible
· 529 Plans can only have one beneficiary so each child should have their own plan
· Create an individual account in the name of the parent, with the child as beneficiary. 529 plans owned by the student’s parent are treated more favorably by financial aid formulas.
· Maximum 2019 529 contribution amount: $15,000 for an individual and $30,000 for a married couple filing jointly per child
· 5 years of contributions could be made all at once in a lump sum of $150,000 for a married couple filing jointly per child
· Anyone can contribute to a parent owned 529 including grandparents
· As of 2018, up to $10,000 can be withdrawn per year to pay for private elementary and high school
Summary
To reach peace of mind in terms of your child’s future education costs, if you live in a state without 529 state tax deductions, open the Nevada 529 plan at Vanguard. Put the account in your name with your child as the beneficiary. You will need one account per child. Check “I want to create my own investment strategy” and select: 60% Total International Stock Portfolio (VEU) and 40% Total Stock Market Fund (VTI). Save as close to $140,000 as you can to fully fund college tuition per child in current dollars. Check back in a year to see if the cost of tuition increased and if there is a change in recommended asset allocation. If you live in a state with state tax deductions for 529 plans, follow the same instructions utilizing the plan offered by your state.