When looking for advice on investing for college, many sources will talk about accounts that shelter income from taxes such as 529 plans and Coverdell Educational Savings accounts. Certainly saving money on taxes is a good thing and something families should take advantage of, but how you save and how you invest is just as important as sheltering your income.
How to save: How you save for college is the same as how you save for retirement – early and regularly. If you can attain a return of 10% per year, you’ll double your money about every seven years. This means you double money you invest when a child is zero almost three times before they get to college, while you’ll only double it once if you wait until he/she is in middle school. If you put away $10,000 when a child is born for college, that would be somewhere around $60,000 – enough to pay for at least a couple of years. Wait until he/she is 10 years-old to invest the same $10,000, and you’ll be lucky to have around $20,000 before he/she heads off to school.
Regular investment is important too. You may not have $10,000 to drop into a 529 plan when your son is born, but if you put away a few hundred dollars per month regularly into a college savings plan and make it part of your regular monthly budget, savings can build up faster than you might think. Regular investing also means that you’ll be buying in during times when the price of your investments slump, meaning that you’ll get a better price than you might get if you just dump a bunch of money in all at once.
Don’t let tax limits limit your investment: If you hit the yearly maximums for tax-sheltered accounts and still have money to save, consider opening up taxable accounts for college saving as well. The amount you save should be driven both by how much you can save and the expected cost of college. Index mutual funds have very low fees and most generate very little in terms of dividends and capital gains during any given year, so as long as you just put money into them and avoid selling shares and moving the money around, you may pay very little in taxes until you start to withdraw the money for college. And even then, taxes may not be so bad since capital gains taxes are often lower than taxes on regular income.
How you invest – be aggressive early: The greatest risk when saving for college is not having enough. When your child is very young – under ten years-old – you have more than a decade to invest. Both of these factors point towards being aggressive with your investments while the child is young. Because the stock market has had better returns than bonds and other assets over virtually every 10-year period, and because stock market returns approach about 12% annualized when held for periods of ten years or more, most of your money should be in growth stocks when your child is less than eight years old.
How you invest – take gains and preserve returns late: As you get closer to your child needing the money, such as when she enters high school, it is time to pare back on growth stocks and start to move into more fixed income assets. This include high yield stocks like utilities and bank stocks, both corporate and government bonds, and REITs. One strategy would be to start at 40% income and 60% growth when your daughter enters high school, then shift 20% into income each year so that they are in 100% income and 0% growth (or even sell some shares so that they are 20% cash and 80% income) their senior year, but this ignores the behavior of the market during those times. If you suffer through a bear market when your daughter enters high school, it makes little sense to shift into bonds and lock in your losses, especially if that would leave you without enough money to pay for college given the 4-8% returns of fixed income assets.
Instead, use the ebbs and flows of the market to time your shifts. If the market has a banner year when your son completes 7th grade, shift some of the money to fixed income early. If the market is routed during their eighth grade year, maybe wait another year for the market to recover a bit before you make the shift. Just keep in mind that stock market returns become less and less predictable as your time period shortens, so always weigh the consequences of suffering loss in your savings to the consequences of not gaining a greater return. If you feel like you have about enough, cut back on your growth stock holdings and move into income and even cash as you near graduation. If you feel like you have a long way to go and losing 20% wouldn’t make much of a difference on your ability to pay for college, stay more invested in growth and wait for a better exit point. Also, look for ways to increase your income temporarily or cut back on expenses to allow you to save more.
The closer you are to even, the less risk you can take: If you have two or three times what you need to pay for college, including both your investments and you ability to pay tuition from your regular income, you can be more aggressive. Even if your stock portfolio suffers a 40% loss, you would still have enough money to pay for things. Likewise, if you only have 10% of what you need to pay for college, you might decide to be more aggressive, knowing that you will probably need to rely on student loans anyway so making gains on your investments would change things more than the suffering of a loss. If you have just enough, however, or almost enough, then preservation of your money becomes the key. Given that it is only four years, leaving little time for inflation to affect your spending power, a staggered set of bank CDs might be the best move if you were in this situation. Even buying into fixed income might result in a loss since you can’t necessarily wait for the bonds to mature so you might need to sell bonds at a loss, leaving you uncovered.
Consider scaling college to your ability to pay: Many people think that their life will be totally different if they get into their dream school than if they go somewhere else. Spend a little time in any college, or look back after graduation, however, and you’ll often find that it is the effort you put in and the things you learn while in school that really makes the difference and not the ranking of your school or the snob appeal of the name. If you have a half million dollars saved up and your son wants to go to Harvard, you could afford the indulgence. If you would need to fund everything on student loans, however, maybe going to a state school would be a good option. Even better – consider having him go to a community college for the first two years and then transfer to a university and save on both tuition and a couple of years’ worth of room and board by living at home. This option would also give your college accounts a couple of more years to grow.
Some investment options: When you’re looking for growth, the best places to be would be in a growth mutual fund, or maybe a small or mid-cap index fund. Reducing fees and expenses is always the key with mutual funds, so take a look at the expenses when choosing between funds. As you start to look for more security and income, shift into bond funds, REITs or REIT funds, utility funds, and perhaps growth and income mutual funds. You can also shift from small and mid-cap index finds and into large cap funds such as an S&P500 fund, which will have larger and more stable companies than a small-cap or mid-cap fund.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.