College Finance Prep

independence_dayMy eldest daughter has another seven years before she begins college,[1] but I’m a planner. The financial burden of my kids’ college looms large, like those spaceships in the Independence Day movies, threatening to block out the sun, and with them, all hope on earth.

Before abandoning everything, running for the hills, and calling Will Smith, I decided to put on my journalist’s hat and call up an expert source.

“Um, hey Mom? I need to learn about how parents pay for college in this era of extraordinarily expensive tuition.”

My journalistic sourcing is way more legit than it may at first appear. Mom has been a college guidance counselor at a private school in Massachusetts for thirty years.

Mom’s first piece of advice for parents of college-bound children is this: while the child is still just a freshman in high school, go online to look up the Free Application for Federal Student Aid – aka Fafsa to figure out your eligibility for financial aid. What you learn from that can help guide your financial strategies for the next few years.

I did that. I learned in about four minutes that I’m not eligible – I mean my kids are not eligible – for a Federal Pell Grant.

Mom’s second piece of advice was to go online to the “net price calculator” of a private four-year college. It turns out, all colleges have these online now. The College Board website helpfully provides a link to 200 such school calculators. Or you can go to individual colleges sites directly.

I picked my alma mater and entered some data on our savings and family income. This took me only another 4 minutes.

After carefully inputting our household income and savings I saw that, realistically, we should start playing Powerball every week.

I’m kidding, never play the lottery. C’mon, man, you should know that the lottery is just a tax on people who are bad at math.

But I realize this four-year college idea sure started to look terrible, at least financially.

“Hey kid, can’t you just make a living curating your own Instagram feed like everyone else does these days, instead of taking Daddy’s money for college?”

instagram_richI think my Mom’s point, without having to spell it out for me, was to demonstrate how terrible the cost of private four-year college can really be.

Indeed one message she would like middle-class families to know is this: Parents have her permission to JUST SAY NO to paying for private four-year colleges. And she has her good reasons. A middle class family with some savings might have been able to shoulder this burden a generation ago, but no longer. I’m not suggesting your child shouldn’t go to college, but rather that financial reality makes a private four-year college a bad deal for most.

I went to a five different ‘net price calculator’ websites to compare the process across schools: a couple of private universities in Texas, where I live; a couple in Massachusetts, where I grew up. In the process I included a very wealthy four-year college with a reputation for scholarship generosity, and another of a school recently featured for having a terribly small endowment and some financial trouble.

I learned that financial aid questions vary greatly depending on the school.

One school asked about the value of our house and how much we still owed on our mortgage, while other schools did not. Some asked whether I owned my own business, or whether I owned real estate besides my home. One asked for my daughter’s GPA, presumably to take “merit aid” into account in our automatically-generated estimate.

Consistently, all schools exempted retirement savings from household assets in their “net price calculators.” I conclude from that fact that if you want to “hide” your assets from colleges for the purposes of getting your kid the most generous scholarship possible, stuffing your retirement account can be a pretty cool financial move.

Another cool idea, which I mentioned last week, is to be born into the right family. Grandparents’ surplus does not count against a college’s financial aid formulas in any of the calculators.

The bigger picture remains that the extraordinary amount of debt parents and their children now take on rarely makes financial sense in the long run. Parents should not raid their retirement savings. Neither parents nor a child should take on high five-figure debt for college. Low five-figure debt, ok, fine, maybe.

Apart from a small handful of the very richest and most highly selective universities – which do offer generous financial terms for lower- and middle-class families – the aid packages of most private colleges render the traditional four-years-on-campus-best-years-of-your-life idyll an unaffordable luxury. Just because we can take on massive federal student loans does not mean we should take on massive federal student loans.

Instead, Mom advocates flexibility and a hybrid approach. In-state tuition at a public four-year college is one approach, although even that has become less affordable as the price of public universities has soared over the past decade.

My mom frequently tells her clients that a few years worth of affordable community college, followed by a transfer to a more prestigious college for the final two years before graduation, can be a pretty cool financial move.

Never_have_childrenBy now you’ve probably realized the most important take-away from this financial column: Never have children.

But if you do have children, strongly encourage them to build a money-making career creating a YouTube channel account, instead of going to college. I’m just trying to save you some money here.

 

A version of this ran in the San Antonio Express News and Houston Chronicle.

 

Please see related posts:

 

529 Accounts are for Grandparents

Want to See Something Really Scary? College Savings

Ask an ex-Banker: Estimating Savings To Prepare for College

Ask an ex-Banker: Using savings v. debt to pay for school

 

[1] “Should she choose that path,” my wife and I always say to each other.

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529 Accounts for Grandparents

lightning_mcqueenIf tax-advantaged investment accounts were characters from Pixar’s Cars movie, I’d award star-status to the 401K as the Lightning McQueen character voiced by Owen Wilson. Meanwhile, 529 education savings accounts would have to be represented by a grandfather-type character – like the Doc Hudson car from the 1950s – voiced by Paul Newman.

I partly assign these roles based on their relative effectiveness in winning the wealth-creation race. If you have to choose where to put your investment dollars, the 401K will get you a lot farther, a lot faster, than the more limited 529 account. Mostly, however, I think 529 accounts not only resemble a slower investment vehicle, they also seem to me mostly useful for grandparents to benefit their grandchildren, rather than for a still-working generation facing limited resources.

I’ll explain my logic, and some of the severe limitations of 529 accounts, as well as why prosperous grandparents looking to help out grandchildren may find them most useful. And then finally, a nod to the social justice issue of 529 accounts.

Grandma vehicle

Unlike a 401K, or an IRA, or even a health savings account, you do not get any federal income tax benefit from your 529 account contributions. Further, if you earn income in a place like Texas (like me!) that doesn’t have a state income tax, you also do not receive state income tax benefit from your contributions to a 529.

Doc_hudsonSo right off the bat, when choosing a vehicle for investing your surplus, you get better mileage out of almost any tax-advantaged account except a 529 account.

It is true that when you finally take money out of a 529 account to pay for a child’s education, you will not pay taxes on income from investments made within the account. So there is that tax benefit of a 529 account, when compared to a fully taxable investment account.

However, here another disadvantage arises, and suggests 529 accounts work better for grandparents than parents – because of college financial aid formulas.

Colleges using the standardized Free Application for Federal Student Aid – known as Fafsa – count the student’s and parents’ income and savings when considering scholarship aid, but do not consider 529 accounts held by people other than a child’s parents. Meaning: Grandparents, take careful note!

Grandma’s 529 account created and held for the benefit of her grandchild will not hurt junior’s chances at a generous financial aid as calculated on the Fafsa. That therefore arguably makes a 529 account more valuable in the hands of a grandparent, rather than a parent.

A further nuance to the Fafsa system soon arises. The Wall Street Journal noted recently that, beginning in the 2017/2018 academic year, a student who receives benefits from a 529 account must report that benefit as the student’s income the following year, which may then affect Fafsa formulas for scholarships in the academic year after that.

For this reason, grandparents who make tuition payments for grandchildren from a 529 could be advised to wait until the student’s final year(s) of college, in order to minimize affects on financial aid packages.

A few other factors convince me that 529 accounts make the most sense for families with well-off grandparents. Unlike IRAs or Coverdell education plans, 529s have no income or age limits on who can contribute, making them suited for older folks with a grandchild they would like to subsidize.

Finally, bolstering my thesis that 529s are grandparent-vehicles more than anything else is the following estate tax strategy:

fafsaIf you are a grandparent with substantial means, then the 529 accounts are a great way to support the next generation, while reducing future estate taxes. Grandad can contribute up to a maximum annual gift tax exemption amount of $14,000 to junior’s future education. If Grandad really wants to get clever, he could combine up to 5 years’ worth of gift-tax exemptions and contribute $70,000 all at once. And then if Grandad and Grandma combine efforts, they could gift up to $140,000 in one year to one lucky grandchild’s education. With multiple grandchildren, and generous grandparents with means, that’s $140,000 per kid all at once, a whole lot of reasons to fund 529 accounts. I mention all this because my sense is that this is a standard estate-tax reduction technique for well-off grandparents.

Limited resources

In all this focus on grandparents, I mean to make the point really for parents trying to decide – with limited resources and a confusing menu of tax-advantaged accounts – where to invest their surplus. And the simplest thing to say is this: always choose a retirement account like a 401K and IRA before choosing the much less powerful 529.

In addition to the difference in tax treatment, another simple way for parents with scare resources to understand the save-for-college versus save-for-retirement is this: You can’t generally borrow money to retire, but you (or your child) can borrow money for education. If money is tight – and I’m only talking to about 99 percent of you now – then always favor contributions to your retirement accounts over educations savings accounts. If you are part of the 1 percent that has plenty of surplus, well then, by all means fill up that 529.

And…social justice

So 529 accounts mostly make a whole lot of sense for a wealthy older generation ensuring their third generation stays ahead in the education game. Which is awesome, don’t get me wrong.

social_justiceBut from a social justice standpoint – if you care about that kind of thing – you might sort of see how the peculiar design of 529 accounts looks terrible. This is basically why in January 2015 the Obama administration briefly floated the idea of eliminating the tax benefits of 529 accounts, which at the time I thought was mean and unfair of them. Unfair, to me, because I have 529 accounts for my kids. But they had a point. According to the Wall Street Journal at the time, the administration argued that 70 percent of benefits went to households with incomes above $200,000, or the top 4 percent of households.

In a non-surprising development, people don’t like their tax breaks taken away, and the proposal lasted roughly three seconds before the administration retracted it.

My social-justice point here on 529s is two-fold – and thematically resembles my approach to advice on many aspects of personal investing. First, the game of investing for college – or anything! – is kind of rigged in favor of the already-wealthy. Second, if that already-wealthy status applies to you, here you go: have some nice instructions on taking advantage of the game.

 

A version of this ran in the San Antonio Express News

 

Please see related posts:

You Want To See Something Really Scary – Saving For College

College Savings v. Retirement Savings

Ask An Ex-Banker: Estimating Monthly Savings To Plan For College

Ask An Ex-Banker: Using Savings Or Debt To Pay For School

 

 

 

 

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College Savings and Compound Interest

clown_under_the_bed

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:

That’s right! Good guessing!3

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.clown trash can

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.

Looking_good_billy_ray

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.

I’m sorry about this, but as you know: Compound interest is powerful.

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.

Here are the relevant facts to back up my assertion, as well as a cool graphic of these statements 9

probability_stocks_vs_bonds
Stocks vs. Bonds given a time horizon

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.

Low probability bet
Low probability bet

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.

  1. 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?
  2. 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.

Best of luck!

Please see related posts on:

Interview with College Advisor Part I – The insanely rising cost of college

Interview with College Advisor Part II – is the 4-year college financial model broken?

New York Times on funding your 401K Account vs. 529 Account

And related post: Stocks over Bonds – The Probabilistic View

And related post: Ask an Ex-Banker: Should I open an IRA?

clown_under_the_bed
You want to see something really scary? Check the College Board Calculators

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  1. Kiddie Park, established in 1925! A Merry-Go-Round from 1925! Scary, scary, clowns!  Oh my!
  2. First, take the Pre-Test! Then the Practice Test! Then the Real Test! Oh my!
  3. As Dora the Explorer would say.
  4. 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.
  5. Everything you need to know about my view on little kid birthday parties was captured recently by Drew Magary at Deadspin.com.  We have got to do something about the Big Birthday Industrial Complex.
  6. 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.
  7. Here’s a nice website for getting starting comparison shopping for 529 accounts.
  8. aka wife.  Also, she’s an MD
  9. Courtesy of David Hultstrom at Financial Architects LLC.
  10. 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.
  11. As my close, personal friend, Nate Silver would say.  (I wish.)
  12. “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.
  13. 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.
  14. 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.
  15. Meaning, you’re going to pay for some kid’s college some day.
  16. 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.