College planning: Reasons NOT to invest in a 529 plan

Financial planners just love 529 plans. They allow clients to pour lots of money into college savings and when we run our computer planning models, the disciplined and dedicated client who saves a ton might actually have enough saved to pay for the children’s college. Financial advisors like that kind of result—neat and taken care of. And 529 plans have that magic attribute—tax free accumulation—that’s catnip to financial planners.

 But there are some good reasons NOT to invest in 529 plans. Before you do, consider the following:

You may need the money for an emergency.

You can’t take the money out (unless there’s a loss in the account) without paying a pretty hefty penalty (10% + income tax on earnings). When your child is young and your career is booming, you may see a smooth road trending uphill. But people do get sick, jobs get reorganized out of existence, and some kids (mine) suddenly need a $15,000 harp. If you have a hefty reserve elsewhere, no problem. But if you don’t, and an emergency strikes, that 529 money can look awfully good, and pretty unreachable.

 You want freedom in investment choice.

You have about the same amount of restrictions and choices as many people experience in their 401ks—preselected funds and portfolios. As many people have learned, don’t believe the rosy perspective in the brochures. Lots of state plans have lost tons of money. Some portfolios charge much higher management fees than if you held the same investments individually (see below). And then there’s that pesky rule that you can only change investments once a year. Normally I’d advocate rebalancing anything only once a year, but I’m a little uncomfortable with this rule given the performance of some of these funds.

If you want individual stocks or a different asset allocation or fund company than the plan allows, no go.

 You have only one child.

This is really a question of how much you save. If you have saved the entire amount of a college education, and your child actually does qualify for some merit or athletic scholarship, or wins the Intel Science Fair, you can withdraw the equivalent amount. That’s a high class problem to have. But what about the child that turns out to be Bill Gates and drops out (see my next point)? If you have other children, you can always shift the money to their accounts or use the money for your own further education, but it’s worth a thought.

 Your child may not go to college.

If the child ends up not attending college or dropping out, it’s the penalty box again.

 Your child is already in high school when you begin to save.

Okay, maybe you weren’t making too much when the kiddo was younger, but income has suddenly taken off. You’re not going to get much benefit from tax savings or long term accumulation unless you’re saving for grad school. If capital gains rates stay low and you’re in a higher tax bracket, you might be better off keeping the flexibility of investment choice (#1 above).

 You haven’t saved enough for retirement.

Here’s where you should NOT put your child first. Your child can take a loan to pay for college, but you can’t take a loan for retirement. Particularly for older parents, this is an oxygen mask situation. Put yours on first.

You’re not going to be able to save very much.

A Coverdell may be as good for small amounts of money (currently, the contribution limit is $2,000/year) and under current rules, money can be taken out to pay K-12 expenses if necessary.

The grandparents might make a significant college contribution.

While it’s true that a grandparent owned 529 is not considered on the FAFSA, some private colleges do ask about such accounts. A planner can analyze whether it might be better for a benevolent grandparent to prepay tuition directly to the college, or pay off the child’s loans after they graduate (also, this depends on the parents’ and child’s eligibility for financial aid).

The tax savings may not be that meaningful.

If you make enough money that the tax savings might be a consideration, you’re probably also making enough money to pay for college out of investments or current salary.

You’d like investments that are consolidated in one place.

I don’t really see the need for lots of special purpose, segregated accounts beyond tax-favored and taxable. It makes rebalancing and asset allocation way harder. And how many envelopes per day do you want to receive from your investment companies?

 You may be paying a lot for the “privilege” of locking up your money.

For example, let’s take a look at Vanguard’s 529 plan under the auspices of the State of Nevada. (NO INVESTMENT RECOMMENDATION INTENDED). I’ll pick their aggressive growth portfolio, designed for kids currently aged 0-5. This portfolio invests 70% in Vanguard’s Total Stock Market Index Fund (Institutional) and 30% in the Total International Stock Index. For this, they charge a .25% management fee (plus $20/year if your balance is below $3,000). Not excessively high. But wait, what if you were to buy these in your plain-vanilla Vanguard account? The management fee for the on the Total Stock Market Investor share class is .18% but you can drop that down to .07% by buying the Admiral shares ($10,000 minimum) or the ETF version. For the Total International, management fees are .26% Investor; .20% Admiral; and .20% for the ETF. Is it worth it?

Let’s say you’re able to front load your savings by putting $65,000 (the max for one contribution) into the 529. You have 70% in the Total Stock Market Institutional, for which your account will be dinged $1,137.50. Put that same amount in a plain old Total Stock Market Admiral or ETF in a regular ole’ account and you’ll be dinged $318.50. It depends on your tax bracket and a lot of personal issues and financial picture, but maybe the tax savings won’t mean as much to you as the increased fees and loss of flexibility. You can buy a bunch of hours of fee-only advice for the difference, and set your whole financial life (not only your kids’ college plans) on surer footing.

 At this point you may be asking yourself why bother with a 529, or maybe, why do I hear so much about them? What’s my usual answer? Well, ask yourself who’s making money off of them? The State? Yup, a decently run one is supposed to make some money (ergo, the higher fees for the Vanguard 529). Brokers? Aw, come on. You don’t really think that brokers would see the potential for making commissions, front-loaded fees, and selling crappy mutual funds with conveniently high management expenses paid by confused and earnest parents, do ya? Well, at least 2 out of three groups win. The only one left out may be the families that didn’t stop to consider their choices.

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College Financial Aid Planning—Deadlines coming up!

College aid forms can seem about as friendly as a 1040, and maybe even more upsetting emotionally. Plus, there are two of them most of us have to fill out—the FAFSA and the CSS Profile. If you’ve been reading this blog you know I advocate submitting the FAFSA on the earliest possible date, or as close to January 1st as you can. But here’s a shocker for most people: if your kid is applying for admission to any school early decision or early action, the school may require you to submit the CSS Profile by November 1st of senior year. For a list of schools that require the Profile in addition to the FAFSA, you can look at the second page of the Profile info from last year.

Be sure you check out not only the application deadlines but the financial aid deadlines. For example, last year Stanford’s early action deadline was November 1st, but their deadline to submit financial aid for early action was November 15th.  However, at the University of Chicago this year, the deadline for early action admission and for financial aid for early action applicants is November 1st.  But whoa, the Profile is only available beginning October. 1st. You’ve got some fun times ahead!

If these financial aid application deadlines are a surprise, well, it points out how important it is to start college financial planning early. Time after time I hear people say, “Well, I don’t have to start yet, my kid is only a freshman in high school”. Wrong! You need to start the intensive part at least that early, but you should ideally take “early action” when your child is a toddler.  The earlier you start, the more likely you are to accumulate savings, and the more flexibility you will have to adjust to changing circumstances. The earlier you start “late stage” planning (at least by first year of high school) the more strategies you can employ to lower your out of pocket costs.

Okay, your student is a senior. What can you do now? You still have about one month to make changes if necessary—contribute to a Roth or IRA or fund an HSA for example. Spend this weekend assembling your 2010 taxes, doing an initial run through of your 2011 taxes. Contact your accountant if necessary, but you can often get an adequate picture if you can match your current figures to last year’s. The Profile will need to be revised after you have 2011 taxes completed, but schools use this first look to tentatively budget their financial aid and give you an early estimate of what you might be awarded. If you have to estimate, estimate on the honest low side (the side that makes you look poorer). And don’t depend 100% to the penny on what the estimate says—it’s not a final offer.

Now would also be a good time to write any letters documenting special financial circumstances—job loss, divorce, illness. In some situations, schools will require documented evidence from a third party. For example, if a non-custodial parent cannot or will not fill out the required document, some schools will require backup information from a disinterested third party.

My best advice is to see a financial planner for help. (What were you expecting?) An early look at your specifics can save you thousands of dollars either by increasing your eligibility or lowering your out of pocket costs. A plan in place can also help you avoid investment and retirement mistakes—college costs can have a domino effect on all family finances. Let’s get going!

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Paying for college without having a heart attack

Only a few short months to go and many of us will be filling out those FAFSA and CSS PROFILE forms and thinking about how much we should have saved. But if you’re a little further from judgment day than I am, let me suggest that the way to eat the elephant is one bite at a time. Or divide the elephant up into three large chunks…

Let’s just assume that you won’t qualify for one penny in aid, and Junior hasn’t been offered any scholarship money at all.

Student contributions—the first chunk

Yup, I said the first chunk. If your kid isn’t willing to invest in his education, why should you? Let’s work with some nice round figures here to make it all easier to calculate. Say four years at Ivy U. costs $60,000/year. Yes, I know that colleges aren’t quite up to that yet, but wait a month or two and we will be. So, four years is going to cost at least $240,000—probably more, with college cost inflation at 6%, but let’s just go with the $240K for purposes of illustration.

Now, I firmly believe that any student, even one whose parents have no problem footing the bills, should be paying something. Not only does it tend to cut out some of the late night booze and barf parties, but it also makes the kid a better consumer. No kid who is working hard enough to come up with $20K a year is going to shell it out for classes in Bowling 101, or tolerate a professor who doesn’t show up for class. As an aside, when I was putting myself through college and grad school, I used to calculate how much each individual class session was costing me, and ask myself if I would put that much money in a meter (had there been one outside the classroom)—did I get as much value from the class as it would take me to earn that much money? Sharpens your focus, no?

So, is it possible for little Jason or Jennifer to earn $20K? Let’s see—15 hours per week for 36 weeks at $10/hour equals $5,400. Then, there’s, say, two weeks at Christmas where you could theoretically work full time—35 hours x 2 weeks x $10=$700. That leaves 14 weeks for summer break. Let’s give Junior a two week vacation. 12 weeks x $10/hour x 35 hours=$4,200. Junior now has $10,300. Sure, I know Junior will probably spend some of this, or taxes will grab a chunk, but then again, Junior probably could hold down 20 hours during school (I used to work 32 hours and take 18 hours a semester as an undergrad. But then, I didn’t have any choice—no one else was paying.) With a little attention to skill development and early hustling, he might be able to nail a job paying a little more. Maybe Jason can mow a few lawns in high school?

We’ve got a deficit here of $9,700/year. It’s grant or loan time. $38,800 will need to be borrowed by Jennifer over four years. Maybe that film or speech major isn’t looking so great right about now. But, under my principal of only borrowing up to what you can expect to make your first year out, I think this is doable. The average starting salary for a college grad in 2011 is about $50,000, according to CNNMoney. Round numbers here, don’t forget. And gosh, if you’re forking over $60K a year for Ivy U., you ought to be able to get a job with at least an average salary. Good questions for the admissions and career services officers.

There are worse things than graduating with 4 years of work experience, a cultivated eye for the bottom line, and some consumer smarts. Some people don’t learn that until they’re 40, if then.

Savings—the second chunk

The next $80,000 should come from savings. I’m not going to go through the growth vs. inflation of the four years of college—you’ll need to come see me for that level of specificity. Let’s just say you want $80,000 “in the bank” by the time Jennifer is ready to move into the dorms. Say you didn’t get religion until she was 10 years old, giving you 8 years to come up with the $80,000. Let’s be conservative and assume a 4% rate of return on your investments. You need to save $8,682/year or about $708/month. (Not figuring inflation—round numbers, remember?) Get going earlier, say when Jason was 5, and you can cut that down to about $4,811/year. I don’t think this is unreasonable—if you’re making enough money that you won’t qualify for any aid at all, you’re making enough to stash this amount of cash. Worst case scenario is you’re grossing at least $130,000/year. At more than $10K a month, it’s reasonable to think you could save less than $400 per month (it’s less than 4% of your gross).

Repeat to yourself as often as needed, “I will not skimp on my retirement savings to fund this.” If you get to this point, it’s time to think about a cheaper college.

Payment from current parental income—the third chunk

$20,000 is around $1,667 per month. Okay, you’re already used to saving $400-$800 per month toward the education, right? Now, Junior isn’t going to be eating at home—say $250 per month in savings right there, maybe more. Gassing the car once a week @ $50=$200. No more music lessons, math tutor, SAT test prep course—well, you get the picture. Most parents don’t stop to think that while they’re paying for the kid at college, they don’t have the kid vacuuming out the refrigerator with 20 of their closest hungry friends at home.

These aren’t authoritative figures and they don’t take into account your particular situation—more than one child at home, no savings, child who takes more than 4 years to complete (oh no!). That’s what individual college financial planning is for–you know, that’s the stuff I do. This is just a suggestion of how to think about dividing and conquering, without the feelings of overwhelm and panic that hit parents toward the beginning of senior year.

 

 

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