When saving for college, parents seek to maximize the amount of money available to pay for college, while minimizing the risk. The goal is to maximize the net worth of the college savings plan, after considering the investment returns, fees, taxes and the possible impact on eligibility for need-based financial aid.
Maximizing Net Return on Investment
The investment options with the highest gross earnings might not yield the highest net earnings, after subtracting fees, taxes and the impact on aid eligibility. All factors need to be considered, not just which option has the greatest returns during the previous year or decade. This yields a few basic principles:
- Time is the Greatest Asset. Parents should save early and often. When parents start saving sooner, there is more time available for the earnings to compound. For example, when a parent starts saving the year the child is born, making equal monthly contributions, about a third of the college savings goal will come from earnings. If the parent waits until the child enters high school, earnings will contribute less than 10% of the college savings goal. In effect, money invested the year the child was born is worth two to three times as much as money invested when the child enters high school.
- Dollar-Cost Averaging. Dollar-cost averaging is a reasonably effective uninformed investment strategy. With dollar-cost averaging, the parent invests the same dollar amount each month, regardless of the performance of the markets. When prices are low, this strategy purchases more shares. When prices are high, it purchases fewer shares. It is similar in concept to the strategy of “buy low, sell high.” Dollar-cost averaging often occurs with automatic savings plans that automatically transfer a fixed amount from a checking account to a savings plan. (Note that when a parent also uses an age-based asset allocation, the initial investment may be according to the principles of dollar-cost averaging, but this will be overridden by the change in asset allocation when the portfolio is rebalanced each year.)
Direct Sold vs. Adviser Sold. Direct-sold 529 college savings plans are sold directly by the state, while adviser-sold 529 plans are obtained through an investment adviser. Direct-sold 529 college savings plans have lower sales and management fees than adviser-sold 529 plans. Even with the higher returns sometimes associated with active management, adviser-sold 529 plans may have lower net returns after the fees are subtracted. Few investment advisers can consistently beat market indexes for 17 years. So, families may obtain a greater net return by investing in a mix of broad-based index funds, such as are available in direct-sold 529 plans, and by minimizing the fees.
Financial advisers may also favor the 529 plans that offer the greatest commission, even though a 529 plan in the parent’s state of residence may offer a state income-tax deduction. On the other hand, a financial adviser may help the parent make smarter investing decisions, such as shifting more of the investment to stocks during an economic recovery, when stocks are likely to appreciate more rapidly than other investment options.
- Minimize Fees. Minimizing costs is the key to maximizing returns. Each state’s 529 plan charges management fees on top of the expenses of the underlying mutual funds. Sales and management fees can significantly affect the net return on investment. If a 529 plan has an 8% average annual return on investment but charges a 1% fee, the fees are consuming 1%/8% = 12.5% of the earnings. That’s much too high. Parents should focus on 529 plans that charge less than 0.5% in fees. Several multi-state 529 plan managers, including Vanguard, Fidelity and TIAA-CREF, have been competing to charge the lowest fees.
- Income Tax Advantages (Earnings). 529 college savings plans are tax-advantaged ways of saving for college. The earnings accumulate on a tax-deferred basis. Non-qualified distributions are taxed at the beneficiary’s rate, plus a 10% tax penalty, which may be lower than the parent’s marginal income tax rate. Qualified distributions are entirely tax-free. State income tax treatment of earnings generally mirrors this federal income tax treatment.
- State Income Tax Deduction or Credit (Contributions). Thirty-five states, including the District of Columbia, offer a state income tax deduction or tax credit on contributions to the state’s 529 college savings plan. Parents can invest in any state’s 529 college savings plan, but can get the state income tax deduction or tax credit only when investing in their own state’s 529 plan, unless they live in one of the six states that provide a tax deduction for investing in any state’s 529 plan. When considering the tradeoff between state income tax benefits and management fees, parents should generally seek to minimize fees when the child is young and maximize state income tax benefits when college enrollment is imminent. Fees are based on the entire investment, including previous year’s contributions, while state income tax benefits are based only on the current year’s contributions. When the child is young, the state income tax deduction will be amortized over a greater number of years, diluting the impact.
Rule of thumb: Let F be the difference in fees, T be the state’s marginal tax rate and n the number of years until college #$%matriculation%$#. Generally, if T < F * n, the 529 plan with the lower fees will yield a greater net return on investment.
- Minimize the Impact on Eligibility for Need-Based Financial Aid. There are several strategies for minimizing the impact of college savings on aid eligibility. Two of the most important concern the treatment of college savings plans as income and assets. Fortunately, 529 college savings plans address both of these concerns.
- Capital gains can reduce a student’s need-based financial aid package by artificially increasing income. Accordingly, parents should avoid realizing capital gains during the base year (the calendar year prior to the academic year) and each subsequent year, or offset them with capital losses. Ideally, parents should try to realize capital gains at least two years prior to enrollment. Note that capital gains realized within a 529 college savings plan will not be counted as income on financial aid application forms.
- Child assets are assessed more heavily by financial aid formulas than parent assets. A child’s eligibility for need-based financial aid will be reduced by a fifth of the child’s ^&*net value*&^ of assets and no more than 5.64% of the parent’s net value of assets. The custodial versions of a 529 college savings plan, prepaid tuition plan and Coverdell education savings account, however, are treated as though they were parent assets. This yields the most favorable treatment for financial aid consideration.
Each parent has a different tolerance for risk. Some parents are risk-takers, while others want to avoid all risk of loss. Generally, investments that yield a higher return also carry a higher risk. Lower-risk investments may not yield enough returns for the parent to achieve his or her college savings goals. The solution is to strike an appropriate balance between risk and return.During any 17-year period, the stock market will pull back at least two or three times. A pullback is a decline of at least 10%, often referred to as a “correction.” One cannot avoid all risk, but there are several strategies that parents can follow to manage the risk.
- Evaluate Investments Annually. Parents should review the performance of their investments at least once a year. If the investments are not performing as expected or if the parents’ risk tolerance has changed, the parents can change the investments or the investment strategy.
- Diversify Investments. Investing everything in a single stock carries a lot of risk. If that stock plummets in value, it can wipe out the investment. One can address this risk by investing in more than just a handful of stocks and bonds. Options like Exchange-Traded Funds (ETFs) and mutual funds invest in a broad variety of stocks and bonds, such as the S&P 500 index. Such investments reduce the risk of any one stock pick causing big losses and, instead, mirror the performance of the stock market as a whole.
- Age-based Asset Allocation. An age-based asset allocation changes the mix of aggressive and conservative investments each year, based on the child’s age or the number of years until college enrollment. When the child is young, more of the money can be invested in stocks and other investments where there is a risk of loss to principal, because less money has been saved and there is more time available to recover from any losses. When college enrollment is closer, more of the money should be invested in Certificates of Deposit (CDs) and money market accounts where there is less risk of loss to principal. This protects the college savings from losses when more money has been saved and there is less time available to recover from losses. A well-designed age-based asset allocation will start with at least 80% of the money invested in stocks when the child is a newborn, and gradually shift the portfolio to a more conservative mix of investments each year, bottoming out with no more than 20% of the money in aggressive investments two years before the child plans to enroll in college. About two-thirds of 529 college savings plans use an age-based asset allocation.
- Bonds Are Not Risk-Free. The value of a bond and interest rates move in opposite directions. When interest rates rise, the value of a bond will decrease if the bond is sold before it matures. When interest rates are low, investing in bonds can carry a risk of loss to principal. This risk can be addressed by holding the bond until maturity, when the full principal value of the bond will be paid when the bond is redeemed. Some bond funds address the risk by investing in short-term bonds. Nevertheless, parents should be cautious if a 529 college savings plan considers a bond fund to be a conservative investment, since there is still a significant risk of loss to principal.
- Stick to the Strategy. When the stock market drops, some parents may panic, pulling out their investments. This locks in the losses and may cause the investments to miss out on the appreciation in value when stock prices start rising again. If one expects the stock market to eventually recover, investing when stock prices are decreasing has the same effect as investing when stock prices are increasing, as one purchases the same number of shares. The only difference is a matter of perspective, where it is more frightening to watch investments decreasing in value. For example, the S&P 500 index dropped by 38.5% in 2008, but increased by 23.5% in 2009. Other parents didn’t pull out their investments, but stopped new contributions. During a stock market downturn, it may be better to increase the contributions to make up for the losses.
Warning about prepaid tuition plans: Although prepaid tuition plans guarantee that a year’s tuition will always be worth a year’s tuition, promising a parent peace of mind, these guarantees may yield false promises. In a prepaid tuition plan, buying a year of future tuition usually costs much more than current tuition rates. The premiums on top of a year’s tuition compensate for past, present and future shortfalls in the prepaid tuition plan’s return on investment. These plans still carry risk, but it is not as transparently disclosed to investors. These plans are squeezed from two directions during an economic downturn. First, lower investment returns and losses may cause an actuarial shortfall, where the plan’s assets are insufficient to pay out projected future expenses. Second, public college tuition increases at above-average rates during a recession and for a few years afterward, as states cut their support of postsecondary education in response to declines in state tax revenues, causing increases in tuition inflation. If a prepaid tuition plan runs out of money, it is unclear whether and how the guarantees will be implemented. No state automatically appropriates funding to cover any shortfall in the state’s prepaid tuition plan, even when the plan is supposedly backed by the full faith and credit of the state. When prepaid tuition plans have performed poorly in the past, states have reacted by trying to retroactively change the terms of the plans, closing the plans to new investment, reducing the financial benefit and increasing the premiums paid by investors to buy a year’s tuition.