FAMILY FINANCE: Saving for College
How families can plan for their children’s higher education.
Kevin Self, Editor
Sending children to college can be one of the most financially challenging times for a family. Parents want the best for their children, but the cost of living - let alone higher education - is not getting cheaper. For a child born today, a four-year, Virginia state college education is estimated to cost over $40,000 per year. Loudoun Family Magazine spoke with Dean Knepper, a local financial expert and the founding principal of Lifetime Financial Planning, based in Leesburg. Knepper, a certified public accountant and certified financial planner, answers questions concerning the best ways for families to save money for college and gives practical advice on how to get started now on your children’s college fund.
Loudoun Family Magazine: When should a family start saving for college?
Dean Knepper: The sooner you start saving, the better. If you want to pay for 100 percent of the projected cost of attending a public university in Virginia, it is estimated that you will need to save approximately $4,300 per year for a newborn until age 18. The amount increases as the child gets older. For a 5-year-old, you must save $5,400 per year and $7,900 per year for a 10-year-old.
This is based on an estimated annual return - after taxes - of 7 percent on an investment portfolio, and a 6 percent annual inflationary increase in the cost of college. For a child 10 years old today, the projected cost for college will be approximately $93,000. For a 5-year-old the cost will be $125,000, and for a newborn the cost will be $167,000.
LFM: If a family has children in high school, is it too late?
DK: For most people, waiting that late in the game is probably too late to save enough money to cover 100 percent of the cost of college, but it is never too late to start saving. If a parent can squeeze $10 a day out of the budget beginning in the student’s freshman year of high school and continue through their senior year of college, there will be enough money to pay room and board for four years at a public university.
LFM: What should a family’s first steps be in developing a college savings plan?
DK: Make goals. Determine what percentage of the total cost - in a state or private school - you would ideally like to pay. Then prioritize the importance of paying for college verses other goals like your desired retirement age. Does a larger home, new cars and expensive vacations take priority over paying for college or saving for retirement? Once you have determined the amount of money you need, start having it automatically deducted each month from your paycheck and deposited into a college savings plan. If additional saving is needed to meet your goal, contribute a portion of bonuses, cash gifts, inheritance and other windfalls to the college savings plan.
LFM: What role can the child play in saving and paying for college?
DK: We recommend getting the children involved at an early age. Have half of allowances, monetary gifts and earnings from summer jobs go to college savings. Get them to understand as soon as possible that mom and dad may not be able to pay for all of the college expenses, and that they will have to pitch in.
When in college, they should support themselves as much as possible by using money from summer jobs to pay for clothing, entertainment and personal care items. According to the U.S. Government Consumer Expenditure Survey, the average family spends $2,650 per year in clothing, personal care items and entertainment for a 15–17-year-old. During the summer, if a student works 40 hours a week for nine weeks at $9 per hour, they can net enough to cover these expenses. This will free up funds that the parent had been paying in the past that can be used to help pay for college. It also teaches the child budgeting and gets them prepared for the real world after college.
LFM: You mentioned retirement goals. For a lot of families it is difficult to save for both retirement and college. What do you recommend for families in this situation?
DK: I encourage parents to first look at their retirement goals and desired retirement ages, and make sure they are taking full advantage of government tax incentives (401(k), IRAs, etc.) to help meet those goals before diverting a large amount of money to college savings plans. Otherwise, they may find themselves working well past the age they had planned to retire. The child can take out loans to pay for college and if the parent’s retirement investments do better than expected, they can always help their children out later by paying off some or all of the loans.
Even if most of their savings is going toward retirement, parents can still save a significant amount for college if they start saving a small amount each week when the child is young. If parents start saving $30 per week when the child is born (increasing that amount each year for inflation) and continue saving through the college years, there will be enough to pay for 50 percent of the cost of four years of education at an in-state public university!
LFM: There are a lot of options out there...savings accounts, CDs, mutual funds. What are some of the best tools a family can use to start saving?
DK: There are a number of options, but there are a few that parents should know about.
First, there is the 529 Savings Plan. These plans, which are offered by all 50 states, allow you to invest tax free to save for the cost of college. Each state’s plan is different, with a variety of investment options. Under most states’ plans you don’t have to live in that state to participate nor are you required to use those funds to pay for the cost of a college within that state. Some states, including Virginia, offer a state tax deduction for contributions to that state’s plan, but only if you are a resident of that state. However, lower fees and better investment choices offered by other states’ plans might more than offset the advantage of the state tax deduction. When determining which state’s plan and which option is best for you, always consider the fees charged, including load fees on some mutual funds purchased through financial advisors. Some states including Virginia give you the option to either invest directly through the state or through a financial advisor, however, the same investment choices are not available under each option. An excellent website to learn more about 529 plans is www.savingforcollege.com.
Second, there are Coverdell Education Savings Accounts (ESA). Formally known as an Education IRA, these accounts also allow you to invest tax free to save for the cost of college. Contributions are limited to $2,000 per child per year. Most mutual fund families offer many or all of their funds as investment choices under these accounts. Many of these funds can be purchased directly from the mutual fund company, while others can only be purchased through a financial advisor. The fees charged on many of the funds that can be purchased directly are substantially less than those charged by 529 plans. Since most mutual funds are available as ESAs, you have a lot more investment choices than under the 529 plans. There are also fewer restrictions on moving investments from one account to another than under the 529 plans. One disadvantage of the ESAs verses the 529 savings plans is the effect on college financial aid eligibility. The ESA is considered an asset of the child while the 529 plan is considered an asset of the parent. Under the financial aid formula the student’s assets reduce aid eligibility substantially more than do the parent assets.
US Savings Bonds are a third option. Interest earned on US Savings Bonds (EE, I, and Patriot) may be tax free if the proceeds are used to pay for qualified higher education expenses of the bond owner, their spouse or dependent. To be eligible for the tax-free treatment, the bonds must have been issued after 1989, and purchased by an individual who is at least 24 years old on the bond’s issue date. The tax exemption on earnings will not be allowed if the bond owner’s adjusted gross income exceeds certain limits in the year in which the bond is cashed. One disadvantage of these bonds is that the earnings will most likely not keep pace with college inflation. The bonds might be appropriate for someone looking for a conservative investment with principal guaranteed by the US Government, or who expects their income will be low enough to qualify for the federal tax exclusion.
The final option we recommend are stocks and mutual funds in taxable UGMA or UTMA accounts. If the investment is held in a custodial account for the benefit of the child (UGMA or UTMA accounts) there are tax advantages that in certain situations may make them more advantageous than the other investment options above. The parent should consult with both their tax and financial advisors to determine if the advantages outweigh the disadvantages. One advantage is that you are not limited in investment options. Another is the possibility of lower fees compared to the 529 plans. In some cases taxes paid when the investment is cashed in may not be substantial. A big disadvantage is that the child receives direct ownership of the assets at adulthood and may use them for whatever they want without restriction. Another disadvantage is that you do not receive the state tax deduction that is available if you invest in Virginia’s 529 savings plan. A third disadvantage is that UGMA and UTMA accounts are considered student assets in calculating financial aid and reduce aid eligibility substantially.
LFM: What degree of risk should a family be willing to assume when investing for college?
DK: I don’t recommend that 100 percent be invested in stocks even if the child is young. You only have to look back to 2000 through 2002 to see what a devastating effect the downturn in the stock market can have on a portfolio that was invested 100 percent in stocks. Also to be considered is that many analysts are predicting a narrowing gap between stock and bond returns going forward for the next ten years or more. I would recommend no more than 50 to 60 percent in stocks for young children and no more than 20 percent in stocks as the child nears college. If the parents are risk adverse, a lower percentage of stocks should be used in the early years.
LFM: If a family has $5,000 to invest the day their child is born, what is a realistic projection for that college fund by time the child is ready for college?
DK: Assuming an after tax investment return of 7 percent and an inflation rate for college costs of 6 percent, $5,000 invested today would pay for less than 50 percent of the first year of college costs.
Dean Knepper, CPA, CFP® is the founding principal of Lifetime Financial Planning, LLC, an hourly fee-only financial, tax and investment planning and advisory firm serving Northern Virginia, Maryland, and Washington DC. Dean specializes in retirement, tax, investment and college financial planning for individuals and small businesses. His name has appeared frequently in the national press, giving advice on numerous financial planning topics including investing, retirement, taxes, saving for college, and college financial aid. Dean is a charter member of The Garrett Planning Network, a nationwide network of Certified Financial Planner® professionals dedicated to providing competent, unbiased financial advice to all consumers on an as-needed basis for an hourly fee.
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