With the impending arrival of our baby, her future and what to do about college savings has been on my mind a lot lately–and I assume many of you parents are in a similar boat. I’m the type that likes to do a thorough analysis before making any major financial decisions, so for something as big (and EXPENSIVE!) as college, I thought I should do a bit of research and thinking BEFORE all the sleepless nights. That way I won’t regret not having a proper plan in place later.
I addressed the question of how to save for our daughter’s college by simply asking myself a bunch of questions. This post contains the answers that we’ve arrived at so far for ourselves for each of these questions. This is subject to change as life happens, and certainly others will have different conclusions, but hopefully what I share can help you in the thinking process and in answering these questions for yourself.
What Are We Saving For?
The common answer for most people would probably simply be: “To pay for my child’s college tuition.” But as I’ve thought more about this question, I had to conclude that this isn’t a totally satisfactory answer. A couple of scenarios came to mind:
- What if my child decides to become an entrepreneur? To start the next Google, Tesla, or even just some small business?
- What if my child decides to become a missionary? To be the next David Livingstone, William Carey, or Bruce Olson?
- What if my child decides to follow a course in life that doesn’t require a traditional college education?
It’s true that our kids will more than likely go to college. However, I don’t know what my child’s disposition will be nor do I know where God will lead her, so I have to accept the possibility that a traditional college education may not automatically be her future path. Besides, I myself did my undergraduate studies at a Bible college that wasn’t accredited. So my savings plan needs to allow for such potential for my child.
So what am I saving for, if it’s not strictly for college expenses? I am saving for my child’s future.
And that may or may not include college.
More than that, I view this as the key part of my inheritance to my children. I believe that the best thing I can give to my children is the ability to lead a meaningful and productive life. To borrow from the old proverb, I’d rather teach them how to fish rather than leave them with the fish that I’ve caught.
I like how Warren Buffett has put it:
A very rich person should leave his kids enough to do anything but not enough to do nothing.
So having this background informs how I view this investment. It’s part of my duty as a parent to provide the opportunities for my children to gain the skills and knowledge needed to become productive members of society and to attain their dreams–and God’s dreams for them. Yet I have to understand that a traditional college education may not be the only way to get there.
How Much to Save?
So having said all of that, we do need to arrive at some objective target in our savings plan. Since a college education is still the most probable choice, and that’s something that’s fairly easy to get numbers on, we’ll use that as the benchmark for how much to save.
Apparently, the cost of college tuition is rising at twice the rate of inflation. According to this CNBC article, by the 2029-2030 school year, tuition at a state college is estimated to be somewhere between $41,000-58,000 a year. At a private school, the amount is more than double at between $92,000-130,000 a year. Compare that to the current, already-high annual tuition rates of $9,139 for state schools and $31,231 for private schools. So for a four-year degree in 2030, it will likely cost over $230,000 at a state school and over $520,000 at a private one. That is an insane amount of money!
The sober fact is that Deb and I don’t earn enough money (and likely won’t for the foreseeable future) to be able to bankroll our children’s college education from our monthly cash flow. The only way that we will be able to afford putting our children through school is if we save up early for it—real early. This is why I’m writing this big blog post on saving for college when our first child isn’t even born yet!
Having said that, our savings fund doesn’t have to cover everything, since we should still be working and can chip in from our cash flow while our kids are in school, plus we expect our children to apply for scholarships and to work while they’re in school. (They’re learning how to fish, remember?)
So based on all of this, we are shooting to save up approximately half of the amount it will cost to go to a state school. That’s about $110-115,000. So with 18 years to go and estimating a 6% rate of return (I’ll share my investment vehicle below), we calculated that we would need to save and invest at least $250 per month today and increase that amount by around 2% each year thereafter. ($255/month the second year, $260/month the third year, etc.)
Fortunately, $250 is a figure that we can reasonably achieve on a monthly basis, largely because we no longer have a mortgage payment.
What Type of Account to Use?
When we talk about college savings, the conversation almost always revolves around the types of accounts to use. Now that we’ve got the other foundational bases covered above, it’ll help us sort out which of the various accounts would work for us and where we should stash that $250 each month.
1. Education Savings Accounts (ESA) & 529 – Both of these account types allow tax-free use of the funds for qualifying higher education expenses. That is why they are the most-recommended for college savings. The funds in these accounts cannot be used for anything other than expenses at an accredited educational institution. One of these would probably be the best option for most people, since the traditional path to most careers go through a regular college education. So if you are interested in saving up for your children’s education, you definitely want to give ESAs and 529s a careful look. They may work well for you.
We’re not entirely convinced they’re for right us however, and it’s largely based on that very first question we asked above.
What if my child wants to get missionary training at a school that’s not accredited? Money in ESAs and 529s can’t help them. What if my child decides she wants to start her own business? We can’t use that money as capital to help her get started. What if she manages to score a full scholarship so we don’t need to pay a cent? Sorry, that money is still locked in for educational expenses and there are a dozen hoops to jump through to be able to access those funds (and a hefty penalty plus tax will be extracted before you get your hands on it). Uncle Sam’s got too many strings attached for our tastes and that’s why we’re not sold on ESAs or 529s. (I’m not saying all types of tax-advantaged accounts are bad, they can be very good for things like retirement and even health savings accounts.)
2. Prepaid Tuition – Prepaid tuition plans do exactly what their names suggest. You pay for tuition today to be “cashed-in” when the child is ready to go to school later. The prepaid tuition plans are usually state-run and are actually one type of 529 plan, so their exact rates and features vary from state-to-state. But here’s an example of how they might work: A state-run school’s annual tuition is $10,000 today. You prepay $15,000 for one-year’s tuition to be used later. In 18 years, you “cash-in” these credits when your child goes to college and tuition is $40,000 a year–saving you $25,000.
These might sound like a decent plan, but these tuition plans can be locked only to be used in the state where they are purchased. I don’t know where my kids are going to end up going to school, and they may not end up going through a traditional path of education at all as discussed earlier. Moreover, some have said that the rate of increase of the prepaid tuition rate is greater than the inflation of tuition itself. Also, with prepaid programs varying so much across the board, it’s unclear whether prepaid tuition really measures up to traditional forms of investing either.
I have a friend in Washington State who is taking advantage of a prepaid tuition program for his kids, called the GET program, and the program is set up to allow for the prepaid credits to be applicable for out-of-state expenses as well. It was a good fit for my friend, and something like that might be available in your State and may work well for you too.
3. UGMA/UTMA – These abbreviations stand for Uniform Gifts to Minors Act/Uniform Transfers to Minors Act. These types of accounts allow for the transfer of assets from an adult to a minor. The way they work is that (usually) parents open one of these accounts for their minor children and deposits funds into them. The funds (and whatever types of investments) in the account actually no longer belong to the adult, but are held in trust until the child reaches the age of majority (18 or 21 years old, depending on the state). Legally, the UGMA/UTMA accounts irrevocably transfer the assets to the child and the parent only acts as a custodian until the kid hits 18 or 21. At that point, the assets all go to the child and they are free to do whatever they want with it–be it college, entrepreneurial endeavors, or something no-good at all.
Simply put, I am philosophically against giving large sums of money to my children like this. Dropping a big sack of cash into the lap of an 18-year-old sounds to me like a disaster waiting to happen. While I certainly believe in teaching a young person how to handle money long before they turn 18, it’s one thing to figure out how to earn it then save it, but an entirely different thing to just be handed a five or six figure check with no strings attached. Again, I’m interested in teaching my children how to fish, not giving them a barrel of fish!
4. Regular Investment Account – In the end, what options are we left with? Basically, just a regular ol’ investment account. Based on our unique situation, this is the option we are choosing to follow. It is the most flexible across the board and also keeps us parents in charge of the money, but the only downside is we’ll have to pay taxes on our gains. That’s a BIG bummer, but we feel it’s a price we are willing to pay to keep our options open. (Update: I did some more digging into the tax ramifications and what I found might surprise you. Check out my findings at the update at the end of this post below.)*
So what if our child wants to start a business, be a missionary, or do something else that 529/ESA/prepaid tuition funds aren’t permitted for? No problem, we can help. What if our kids end up going through college and through a combination of hard work, scholarships, or other things didn’t use up all the funds allocated for that purpose? No worries, that money can then be applied to other pursuits to help them make a difference in the world.
We don’t want to limit our children or their potential. So in the end, we realized that this needed to be reflected in our investments intended to help them reach that potential.
How to Invest that Money?
Just determining the type of account isn’t the end of it, there’s the question of what I’m actually going to invest in within the account to hopefully take advantage of the wonder of compound interest to increase the efficacy of my savings.
We are opting for something super simple: Just ONE mutual fund. We don’t have to worry about rebalancing multiple funds, we don’t have to worry about tax-loss harvesting, we don’t have to worry about timing the market, we just set up an automatic deposit into this mutual fund every month for the $250 that we have agreed upon.
We’re going with the Vanguard Target Date Retirement 2045 (VTIVX) fund. This fund (along with all of Vanguard’s Target Date Retirement funds) automatically adjusts the asset allocation between stocks and bonds as we near the target date to compensate for risk, so I don’t have to worry about it. While the 2045 target date is 30 years down the road and much farther away than when my daughter (hopefully!) will be ready for college, I opted for this fund because the asset allocation mix is closer to what I prefer than the 2035 target date fund. It’s also likely to return a slightly lower rate of return than the typical 8% benchmark for the market that I reference, but that’s in exchange for a smoother ride and less volatility in the investment. There’s never a substitute for having your own understanding of what you invest in, so if you’re interested, please check out Vanguard’s Target Date Retirement funds info page to see more for yourself.
I’m a big Vanguard fan and they are the only investment company I recommend anymore. The target-date retirement fund requires only $1000 to get started (as opposed to $3000 or more for the other funds), and the expense ratio (how much Vanguard charges to manage the fund) is only 0.18% (that’s very cheap). It’s the simplest, most affordable solution out there and we’re just going to let the thing ride until we need that cash to pay for our daughter’s future.
So now that we’ve figured out why we’re saving, how much to save, and where to invest it–what now?
Start saving! ASAP!
With a target amount of over $110,000 needed in approximately 18-20 years, we need to start NOW to take advantage of the secret ingredient of investing: time. The longer the money gets to compound, the greater the tailwind to get us to our target amount.
But beyond simply getting started, we also need to make a pact with ourselves that despite the guaranteed gyrations of the market and the inevitable market crashes that happen on a regular basis, we need to remain disciplined in our saving regimen and invest for the long haul. For a good read that simplifies this important concept, check out Jim Collin’s Stock Series here.
Also, along the same line, we need to remember that we’re not saving for a vacation or a new gadget, but rather for our child’s future. So every little “emergency” or “opportunity” that arises is not reason to touch this money. We need to resolve that our children’s future is far too important to allow raiding it to meet some other want.
Here’s to the dream that someday our children will thank us for teaching them how to “fish” for themselves, and to accomplish that without the stress of draining our bank accounts or packing on debt to do it.
How do you save for your children’s future? What philosophy do you adopt toward your children’s future education? Share with us in the comments below!
* Update (9/2/2015): Some further discussions have led me to dig a little bit deeper into the tax implications for investing in a taxable account as I am planning. As of 2015, the capital gains tax rate (what is taxed on long-term capital gains and qualifying dividends from our investments) is 0% for those in the 15% federal income tax bracket. Since that’s the tax bracket we fall under (and will be in for the foreseeable future with Deb staying home and all), we will owe no capital gains taxes to the federal government. Tennessee has no personal income tax, but they do have a 6% capital gains tax on gains exceeding $2500 per married couple per year. So comparing this to the 529 account, where I have to pay taxes on gains at my then-current tax rate plus an additional 10% penalty, it appears that sticking with a regular taxable account affords greater flexibility for usage of the funds and at the same time would be cheaper if not used for qualifying higher education expenses. Of course, all of this can change if tax laws change, but currently this seems like the happiest medium. If things change drastically and it becomes advantageous to do so, we can always take the taxable account and dump it into a 529 too. Finally, I saw a Bogleheads forum discussion on this very point, and some of the commenters had some good insights.