An astute reader pointed out some qualifications to my Friday post on 529 college savings accounts – specifically, reasons not to fund them. The most compelling reason, coincidentally covered in the next day’s New York Times, is that funding your 529 accounts is not as important as funding your 401K retirement account.
The New York Times article, which is worth reading in full, makes the following correct argument: If you have to choose between fully funding your 401K vs. funding your child’s 529 education account, fund the 401K account first.
The first reason for this is that many people can borrow money to fund a college education, but we will have a harder time borrowing to fund our retirement. Another reason is that the income tax advantages available by funding a 401K – available to everyone subject to federal income taxes – are far greater than the potential state income tax advantages of a 529 account. In addition, 529 account generally do not trigger employer matches the way many 401K plans can.
In sum, all my big tough talk about funding one’s 529 account only applies after you’ve fully maximized your 401K plan contributions.
My littlest one turned four years-old last weekend1, and my eight year-old is taking a Texas-Public-Schools-3rd-Grade-State-Mandated-High-Stakes-Standardized-Test this week2, so you can probably guess what’s on this ex-banker’s mind:
Time is quickly running out for me to save money for their college tuition.4
The only thing scarier than those scary scary clown head trash cans at my littlest daughter’s birthday party5 is the prospect of saving enough money for her college tuition.
For my eight year-old, I’ve got just 10 years to go before C-Day, so I thought I’d share my current ex-banker thoughts with others, in the hopes that we can experience this horrific fear together.
Also, “saving for college” allows me to discuss my favorite topic (compound interest!) so that’s always a good enough reason by itself for a Bankers Anonymous post.
I see three big questions about college savings, with the most interesting one being #2.
Question #1: What college savings account or investment vehicle, if any, should I use?
Question #2: How much do I need to save, per month, to be totally set for college tuition payments when they arrive? (Compound interest calculations coming up! Yay!)
Question #3: What kind of investments do I need in my college savings account?
I’ll take these in order.
Question #1: What savings account or investment vehicle, if any should I use?
Open up a 529 College Savings account.
Ok, that was easy.
But, why a 529? Also, which one?
The first “why” is because you may get an income tax advantage when you make a 529 account contribution, depending on the state you live in. When I lived in New York and paid New York state income tax, I enjoyed an income tax break on my contributions. Now that I live in Texas, I get no state income tax advantage from 529 account contributions.6 So that may, or may not, apply to you.
The second ‘why’ is that any capital gains or investment income – which might be triggered when I sold stocks or earned interest on my investments – remain protected from taxation in that year, assuming I do not make withdrawals from my 529 account. If I just held my college savings in a regular, taxable, brokerage account, I’d be required to pay taxes on capital gains or other income from my investments. The result of this 529 account tax protection is that I can grow my money much faster than in a regular, taxable, brokerage account.
Ok, so that sounds good, but which 529 account should you open? Probably you should start by investigating your own state’s offering7, precisely for that potential income tax break. But if you live, as I do, in a state without an income tax, then you can consider other advantages, having to do with
a) Contribution limits – Some states allow higher contributions than others
b) Flexibility of investment choices – some states offer restricted types of investments
c) Cost of available investment choices – some states offer higher-cost plans than others
d) Convenience
I opened a New York state account for my oldest daughter because we lived there, then. My youngest was born in Texas, but I opened a New York state account for her as well, purely for convenience sake. I prefer tracking both girls’ college savings information on a single website.
Question #2 – How much do I need to save, monthly, to have everything covered?
The College Board (The fun group that brought you the SAT, the PSAT the AP tests, and more!) has a couple of incredibly useful online calculators.
First, they can help you figure out how much of college’s cost you, as a parent, will likely have pay. To try the calculator, go here.
This calculator asks some specific questions about your family situation, plus your income and savings, and then tells you how much the financial aid department of a college will likely expect you to contribute for your child’s annual college expense.
Beware, because [**Spoiler Alert**]
This number will be much higher than you want it to be.
I don’t think of myself as wealthy, and generally we don’t have much left over at the end of the month. Which is why the expected contribution number from a typical financial aid department left my face feeling a bit tingly.
Is it getting warm in here, or is that just me? My editor-in-chief 8 thinks I’m either suffering from menopause or anaphylaxis based on these symptoms. We’ll just have to wait and see.
Next, the College Board has a great college savings calculator to tell you how far your current plan will go toward paying for college. Before you go there, I’d like to warn you – the result is scarier than scary, scary, clowns.
First, you input the current cost of college, an assumed rate of tuition inflation, how many years your child will attend, and how much you will likely have to pay, which you may have some idea about based on the first online College Board calculator above. Next, you input how much you’ve already saved, what you expect your annual investment returns will be, how many more years you have before your child goes to college, and how much you plan to contribute monthly, between now and then.
You input all of that, and then you have a heart attack immediately and die, because there’s Just. No. Way.
I personally can’t feel the whole left side of my face right now.
For example, let’s say I’ve managed to put aside $19,000 for my 4 year-old up until now.
Looking good, Billy Ray.
And let’s say I plan to invest $200 per month until she turns 18, and I can earn a 7% return on my investments, via my 529 account.
Feeling good, Lewis.
Also, assume a private 4 year college costs $50,000 per year today, the college cost inflation rate is 5%, and I plan to pay 90% of that from savings.
I have an estimated shortfall of $276,399.
Randolph, this isn’t Monopoly money we’re playing with.
Some of you clever readers may just be smirking because your little darling will likely either get a ton of scholarships or else attend a state college, no?
Well, the bad reality is that state college isn’t that affordable these days either.
The average 4-year in-state tuition cost, according to the College Board, will set you back $21,477 this year.
If I have zero savings for my 4 year old, but I manage to invest $200 per month, starting now, and she attends an average cost in-state college, I’m still $107,582 short, 14 years from now.
The answer to the question “how much should I be saving per month to be totally set for tuition” is provided by the College Board calculator, just under the shortfall number.
After you recover from this shock, you’re ready to move on to question #3.
Question #3 – How should you invest your child’s 529 Account?
This one’s easy, and frequent Bankers Anonymous readers will not learn a single, damned, new thing from me here, because the answer is unchanged from previous, similar questions about how to invest for the long run.
Hopefully you noticed, from playing around with the college board’s calculator, that you need a fairly high rate of return on your investments from now until college to even have a chance of closing the gap between your current savings and how much you’ll owe for your child’s college, every year, for four years.
Now, since returns have to be high, you have precisely one choice for how to invest: 100% equities.
Let me further clarify, in a way that will again make me sound like a broken record for careful readers: You need to invest your long-term savings for college in a highly diversified low-cost (probably indexed) mutual fund, invested in stocks only.
Why 100% equities?
Why not bonds or other safe investments? Two reasons.
The first reason is low returns. For the vast majority of us, we can’t afford to invest in bonds over the medium to long run. An intermediate-term bond fund will return somewhere between 0.5% and 2.5% right now, and that’s just not going to cut it.
The second reason is that – on a probability-adjusted basis – you will get more from investing in equities.
If you have a 5-year investment horizon, you will be better off entirely in stocks, rather than bonds, 70% of the time.
If you have a 10-year horizon – as I do – you will be better off entirely in stocks rather than bonds, 80% of the time.
If you have a 15-year horizon – as I do with my youngest daughter – a 100% stocks portfolio10 outperforms a 100% bonds portfolio 90+% percent of the time.
Is that guaranteed? Of course not
Probabilities are not the same as guarantees,11 so of course the bet you make on investing in 100% equities in your child’s 529 account could go wrong. But making the other choice – including bonds in your portfolio – is a low probability bet. By investing in bonds you are implicitly saying “Probabilities be damned! I don’t care about history! This time is different!”12
Look, I play poker with the neighborhood dads, so I know that low-probability bets sometimes work out. But I also know it’s kind of stupid to make low-probability bets. Trust me, because I’ve been losing $20 a week on a regular basis to these guys, testing this hypothesis, since I’m not a strong poker player.
You can decide to weigh down your kid’s college savings account with bonds, and you may be under the illusion that this is ‘prudent’ because they’re bonds and “bonds = safe.” But it’s not prudent, any more than it’s prudent to bet with jack seven off-suit.
Would I advocate investing in 100% equities if my kid is going to college next year?
Well, this gets trickier. Stocks still beat bonds in most years, so if you want to play the odds – and if you have some kind of cushion – you could reasonably keep the account in stocks. Most of the time – on a probabilistic basis – this would be a winning choice.
But I realize this seems a bit extreme, so with one year to go I’d probably take next years’ tuition (potentially only 1/4th of your position) and plunk it into a risk-free investment, like a money market fund13, and leave the rest exposed to stocks. Remember, 3/4ths of your account has more than one year to remain invested. Each additional year invested increases the probability that stocks beat bonds.14
Tick Tock Tick Tock
For my wife and me, that loud ticking we hear is not the biological clock anymore, but rather the college financial clock.
For anyone in our demographic15 who checked the College Board calculator,16 I’ll now sum up the only other good pieces of advice I can think of related to saving for college.
Open up a 529 Account for each kid. Like, right now. Stop reading blogs and do this immediately. Really. Did you do it yet? How about now?
Set up an automatic withdrawal from your bank account, so you don’t have to make a choice about contributing every month. Because if you have to make the choice every month, the money might not be there. Even $25 per month in automatic withdrawals is better than nothing. Increasing that $25 monthly contribution over time, once the account is open, will be much easier than you think.
My wife and I like to jokingly append “–should they choose that path,” whenever we discuss our daughters going off to college, but the fact is that’s our chosen path for them and they can deviate from it at their peril. I’d like to see you just try it, kiddo. ↩
In a news item that may or may not be directly related to this fact, my local urban school district boasts 7% college readiness among its graduates. I will now light myself on fire. ↩
Hopefully the following is obvious, but just in case it’s not: When I say 100% stocks I mean a highly diversified mutual fund, not an individual stock or even a small group of stocks, or a single stock sector. When I say bonds I really mean a AAA-rated bond fund of, say, intermediate duration. Not junk bonds or emerging markets or anything else interesting and high-yielding. ↩
“This time is different” is one of those investing No-Nos as a justification for making an investment decision. “This time is different” is a fine gambling notion (for investing in individual tech stocks, for example, or buying into a venture capital fund) but is not a fine investing notion. ↩
Why a money market fund and not a bond fund? Because a bond fund, with only one year to go, could actually lose money as well – in a rising interest rate environment – so only a money market fund guarantees you zero volatility of results. ↩
Incidentally, investing today for your kids’ college next year is NOT the way to do this. Sorry if you are reading this with a 17 year-old breathing down your neck. 529 accounts have little to offer in this case, and compound interest can’t help you much either. ↩
Meaning, you’re going to pay for some kid’s college some day. ↩
And if you haven’t yet used the calculators, have a swig of whisky and then seriously you should go check them, it’s the right thing to do. ↩
When I was a ‘debt buyer,’ acquaintances would occasionally ask ‘Oh, could you buy my debt?’
(and I would think, “uh, that’s not how it works.”)
That question told me two things:
1. Most people do not know that all banks and most investors are ‘debt buyers’ one way or another.
2. Most people don’t understand that the monthly interest they pay on credit cards, car loans, and mortgages all form someone else’s “yield” on an investment. Up until about 30 years ago that someone else would have been their bank, but in recent decades their interest yield typically goes to the investor in an asset-backed bond.
I passionately believe that understanding the math of compound interest will help you think like a bank or investor.
In either case, more people should understand – for personal finance reasons – the connection between the interest they pay and the growth of someone else’s money. Because if you reverse the order – if you yourself become the lender or investor of capital – then you get to earn the compound return available from someone else’s interest payments.
Understanding the compound interest formula – which shows the growth of money today into larger amounts of money in the future – helps provide the mathematical insight into this idea of debt interest = yield.
Why is money today more valuable than money in the future? In this lecture to students at Trinity University (in San Antonio, TX) I review four reasons why in any real-world scenarios I can think of, a reasonable person would give me less than $100 today in order to receive $100 from me one year from now.
To dig into the math of compound interest, discounted cash flows, and interest rates (or yield) its useful to review the practical fact – employed in all banking, insurance, borrowing/lending, and investing activities – that money today is worth more than money tomorrow.
In order to not play hide-the-ball with this video, here are my four reasons for why money today is not equal, and is more valuable, than money in the future:
1. Expected inflation (aka expected loss of purchasing power in the future)
2. Expected return (holders of capital demand a positive return on capital)
3. Risk of future payment (aka credit risk or counterparty risk)
4. Liquidity of capital provider (relative scarcity today raises value of money today for capital provider)
For all four of these reasons (and possibly more) holders of capital can demand a positive return, or interest rate, for the use of their capital. This justification for charging interest, or demanding a positive return on capital, or yield, is the foundation of every financial transaction.
In my ongoing, epic, lonely, quest to convince an indifferent world that the compound interest formula will clothe the downtrodden, feed the grey whales, prevent the coughing sickness and otherwise save the planet, I offer this video explanation for what the compound interest formula does.
I’m teaching personal finance to college kids this semester, so I plan to offer these video snippets on a semi-regular basis. I’m still new to video, so (gentle) criticism, (thoughtful) suggestions, and (full-throated) praise are all welcome!
Last night completed Day 30 of the “Allowance Experiment,” in which I offered my eldest daughter a daily payment calculated as 10% of her allowance savings, compounding daily. On day 1, she began with an initial grub stake of $1. She received $0.10 on day 2 (10% of $1) and $0.11 on day 3 (10% of $1.10), and so on.
By Day 30, however, due to the magic of compounding, the daily payment grew to a substantial $1.44. At the end of 30 days, she had $15.86 in the money jar. That’s a pretty good sum for an 8 year old, because she can buy any ice cream her little heart desires, and $15.86 is also approximately 1/1000th of the way to obtaining an American Girl Doll.[1]
With this kind of experiment, one must stop after about a month. Otherwise – because compound interest turns money into kudzu crossed with HGH crossed with a mutant Godzilla[2] – by 6 months of this I would end up paying her $2.1 million per day, and she would have over $25 million in her jar. At which point obviously I’d be asking her for a daily allowance.
Plus with $25 million in the bank she could afford to purchase approximately 2 American Girl Dolls at the same time.[3]
Unexpected benefits
As I wrote before, one of the beneficial side effects of the allowance experiment – because I required her to do the daily interim calculations of 10%, plus adding up the totals in the jar – was appropriately difficult math for a 3rd grader. This is smart parenting.
You know what else is smart parenting? When she messed up the calculations. For example, when the 10% number she calculated ended up larger than it should have been, I immediately pointed out her error and asked her to try again. I was not about to pay any more than I had to.
But what about when she messed up the calculations and it worked in my favor? What about when she asked me to pay less in compound interest than I should?
Well, let me just say that all’s fair in love, war, banking, and parenting. I mean, you can take the Dad out of Goldman Sachs, but you can’t expect to take Goldman Sachs out of the Dad, now can you?
Plus, as (my guide to all good parenting practices) Jack Handey points out, kids like to be tricked.[4]
The main point, accomplished
All jokes aside, the point of this experiment was not so much to induce savings or to teach basic math, but to viscerally illustrate the powerful force of compound interest.
I asked her if she understood the way in which money grew at an accelerating pace with regular 10% compounding. She responded with a wide-eyed, “Yes, it gets really big.”
[1] That last number is just a price estimate based on gut feeling. I haven’t looked it up.
[2] “Kudzu crossed with HGH crossed with a mutant Godzilla” is the name of my new favorite funk band. Also, I’m going to copyright it as a title for my book on compound interest, so don’t even think of copying it.
[4] From the parenting guru himself: ‘One thing kids like is to be tricked. For instance, I was going to take my little nephew to Disneyland, but instead I drove him to an old burned-out warehouse. “Oh, no,” I said. “Disneyland burned down.” He cried and cried, but I think that deep down, he though it was a pretty good joke. I started to drive over to the real Disneyland, but it was getting pretty late.’