Editor’s note: This is part one of a three-part series about college 529 savings plans. Part two is What You Need to Know about College 529 Savings Plans, and part three is College 529 Savings Plans: How to Get the Most Out of Them.
The average cost of public in-state college tuition, fees, room and board in 2020-21 is $26,820 a year and $54,880 for a four-year private college, according to a recent study by the College Board. For a child born today, the four-year cost of college is expected to be $526,629 for private and $230,069 for public, according to a recent study by J.P. Morgan. Imagine if you have two or three kids?
True, there is financial aid, merit and athletic scholarships. Most schools discount the sticker price. But there is no guarantee your child will receive aid, so we must plan. Sadly, I find most parents lack a plan for college savings. Parents have good intentions and care for their kids, but for one reason or another they never get around to setting anything up. Parents who say they do “have a plan” often are merely throwing some money aimlessly into an age-based 529 college savings program. That is a good start, but not enough to meet the six-figure future cost of college. Planning for the astronomical cost of college requires more. It requires a thoughtful, meticulous plan.
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For my clients, we start with reviewing their goals and objectives. We review the expected cost of public and private college in their home state. Then parents may decide to try to cover 100% of college costs, 50% or maybe a third. Having a goal in mind is extremely important. It creates motivation and lessens anxiety. We then review their monthly cashflow to find a number they feel comfortable allocating into a college savings program. From there we devise a holistic plan. We review their employer plans, such as deferred compensation or company stock plans, insurance needs and expenses, discuss retirement savings, inheritances and anything else that’s important to the conversation. We then review several college saving recommendations.
Here is one: Forget age-based options.
How parents fail to make the most of 529 plans
You probably are familiar with the 529 college savings plan. These programs are a solid choice for college savers. Contributions are after-tax (no federal tax-deduction up-front), earnings grow tax-deferred, and withdrawals for qualified higher-education expenses (room, board, tuition and some fees) are income tax-free. In addition, assets in a 529 plan receive preferential financial aid treatment when owned by a parent. A maximum of 5.64% of parental assets count toward a family’s Expected Family Contribution (EFC) when applying for federal financial aid, versus 20% of a student’s assets (Source: Savingforcollege.com). There are penalties for not using 529 money for college, namely a 10% penalty on withdrawals, plus the earnings are income taxable.
Many parents are familiar with 529s, but many don’t fully utilize the program. In practice, I find parents contributing monthly to a 529 into an age-based mutual fund. On the surface this seems logical. An age-based mutual fund invests in more aggressive equity mutual funds for younger children, then automatically shifts to more conservative bonds as the child ages and gets closer to college. This makes sense, as you want 529 money to be conservative as the child gets closer to withdrawing the money for college. Age-based funds are set-it-and-forget choices, meaning busy parents don’t have to manage the investments themselves.
Personally, I don’t care for age-based options.
Age-based mutual funds are for the most part too conservative. For example, Vanguard’s 529 age-based mutual funds own some bonds for all ages, starting at age zero! This means a newborn, 18 years away from needing the money for college, has some conservative, low-yielding bonds in the account. Fidelity’s Connecticut Higher Education Trust (CHET) 529 age-based option for a child 18 years away from college — the 2039 portfolio — has 5% in bonds. The 2036 portfolio — for a child 15 years from college — has 14% in bonds.
This is a huge mistake, in my opinion. Bonds are too conservative for a child that young. I understand the importance of asset allocation, having been in the business for 20 years. I use bonds to diversify portfolios and believe bonds play an important role in helping a portfolio weather a stock market storm, as bonds usually hold up better in a stock market crash. But I also understand that a newborn child has a long, long time before needing the money for college. In 18 years, the child’s account will see many stock market corrections, booms and busts. I am not so concerned about a dip in the stock market with a child that young. I more concerned about the skyrocketing cost of college, otherwise known as inflation.
The real risk is inflation
Forbes recently reported the cost of attending college rose more than twice as fast as inflation. More than twice as fast as inflation! Costs rose 497% from 1985 to 2018. Good luck beating that inflation rate with low-yielding bonds.
Inflation is the real risk to a newborn, not a stock market correction when the child is 5 years old. Not only that, but if interest rates rise, bond prices may fall, making bonds by some measures riskier than stocks.
A better way
My advice: Forget age-based 529 options and pick the funds yourself, based on your time horizon of needing the money for college. Children more than five to seven years away from college may want to consider an all-equity portfolio to maximize growth. Given the high cost of college, you will need all the growth you can muster from your investments.
If you still want some fixed income in your 529 plan, you should ask yourself: What is the best approach? Does a bond index make sense? Probably not in this low-rate environment. A bond index owns short- and long-term bonds. Long-term bonds have more interest rate sensitivity, meaning if rates rise, your principal will likely go down. You should check whether your 529 plan offers an active fixed income manager to provide some investment flexibility. An active fixed income manager may have higher fees than an index but can better manage the fund for yield and adjust the holdings if interest rates do rise. Some 529 accounts offer a “stable-value” option, which may be lower yielding, but has better principal protection than a bond fund.
Other considerations
Start with reviewing the 529 plan of your home state versus an out-of-state 529. Does your state offer a tax-break for contributions to their 529 plan? Even so, how do the fees compare with your resident state’s 529 versus another state’s plan? You can use a 529 plan in other states. Some states, including California and New Jersey, offer no state tax break for contributions. Either way, you should compare the fees and mutual fund options in your state’s plan versus an out-of-state 529. Just because a state offers a state tax deduction for your contributions doesn’t make it a “good plan.” Besides, the state tax deduction doesn’t usually amount to much either. Other states’ 529 plans may offer lesser fees or better mutual fund selection.
I like 529 college savings plans and have three accounts myself, one for each of my three children. But when it comes to picking a 529 plan and choosing the right mix of investments, I encourage parents to use a little more discretion. A little effort today in choosing the right 529 plan or managing the investment choices can pay bigger dividends for your child in the future, quite literally.
Investment advisory and financial planning services are offered through Summit Financial LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This material is for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting with their independent tax or legal advisers. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not a guarantee of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Links to third-party websites are provided for your convenience and informational purposes only. Summit is not responsible for the information contained on third-party websites. The Summit financial planning design team admitted attorneys and/or CPAs, who act exclusively in a non-representative capacity with respect to Summit’s clients. Neither they nor Summit provide tax or legal advice to clients. Any tax statements contained herein were not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state or local taxes.
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