Tue, 30 Aug 2016
Don't panic, consider your options, and be careful with asset allocation when it comes to saving for college.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. As kids go back to school, I'm sitting down with Christine Benz, she is our director of personal finance, for three key must-knows for parents saving for college.
Christine, thanks for joining me.
Christine Benz: Jeremy, great to be here.
Glaser: So, your first must-know is don't panic, which I know is easy to do when you look at some of these headline numbers of how much school costs these days and also how fast that's growing.
Benz: It has. The rate of college tuition inflation has been extreme relative to the inflation rates elsewhere. And certainly, the numbers, when you look at tuition for even in-state public universities, $25,000 today, upward of $30,000, sometimes upward of $50,000 depending on the private university per year. These numbers are really off-putting. And so, I think a lot of parents who feel that they maybe haven't prioritized college savings maybe as much as they wanted to when their children were young, might even be inclined to say, you know what, we're so far behind on this, why even bother?
And here, my point is that every little bit counts. And for a lot of families I think it just helps to bear in mind that no, you may not be able to do all of the heavy lifting with your own earmarked college savings, that the reality is for a lot of families the tuition gets paid for through a variety of sources. So, yes, it may be personal savings, and the more the better obviously. But financial aid and scholarships figure into the mix, work study for your child may figure into the mix. A lot of families I know, and granted this is anecdotally, but they simply tighten their belts in the years that their kids are in college. That may not be what they really want to do but they do it, and two-earner households certainly have more latitude to do that, but they fund those college needs on sort of an ongoing basis in part just due to their ongoing income flows.
Glaser: You think the second thing that you need to keep in mind or at least know about is the different types of vehicles for saving for college. There seems to be a lot of options there. What do you think is the right one for most investors?
Benz: Well, it can be a little confusing. So, I guess, my key message here is, don't get too bogged down in all the choices. There are a couple of key ones to focus on. The Coverdell Education Savings Account is maybe kind of a good first stop, especially for smaller college savers but there are income limits on who can contribute, and you can't contribute very much currently. So, it's just $2,000 per year. Looking at some of the numbers we are just talking about, you can see why you need to be much more aggressive in terms of your savings rate than that.
So, for most families the 529 savings plans will be the most effective mousetrap for their college savings. The good news is that these plans have generally gotten a lot better over the past decade or so, and I would say that that owes in no small part to our team here at Morningstar who covers the 529 plans, and I think frankly has shone a light on some of the expensive options, some of the sub-par investment choices. In general, we've seen 529 plans come up quite a lot in quality across states. So, for most families, especially those looking to sock away a fair amount of money for college that in-state college savings plan is probably going to be your first stop. There may be a few where they are really not great options, but the benefit of sticking with your home state's plan, and this is the saver's home state plan, is that you are typically able to obtain some sort of a tax break on your contributions, a state tax break and that will come in the form of a deduction in most cases or it may be a credit. So check that out. Make that the first thing you check up on, and we do have a good college savings center on Morningstar.com where you can kind of look at the map and look at all of the states' plans, but start with your home state.
Glaser: So, I'm here in Illinois. My nieces are in Pennsylvania. Let's say they go to school in California, it doesn't matter that the money I'm putting away for them would be here in the Illinois plan?
Benz: Right. And it's, kind of, a judgment call. If you are looking to just maybe steer $100 a year into their account, that may be a reason to just put it into their home state account where maybe the parents are contributing as well. But if you're looking to contribute a significant share on their behalf that really benefits you to prioritize your home state's plan. That's where you'll obtain the tax break, and it doesn't matter where they go to school. This is a common misconception about 529s. I think people are getting a little less confused about this than they once were. But if you save in the Illinois plan, you are by no means wedding your nieces to having to go to school here in Illinois.
Glaser: Now the Roth IRA is sometimes touted as a multipurpose saving vehicle for college as well. But you think that's not as good of a choice as a 529?
Benz: Well, for a couple of reasons. One is that it's primarily a retirement savings vehicle. So, while it is among the most flexible savings vehicles out there, in that you can withdraw your own contributions at any time and for any reason, I do think that for most people they'd want to leave their Roth assets alone and earmark them for their own retirement savings rather than tap them for college. The other reason is that you can only get $5,500 a year into a Roth IRA, $6,500 if you're over age 50 and that's just not going to do the heavy lifting for college savings, especially if you're hoping to use part of that money eventually for your own retirement savings. So, I wouldn't prioritize the Roth IRA.
Glaser: What about something like a UGMA? Is that not a good option here?
Benz: Well, it's certainly an easy option. So, if you want to open an account on behalf of a small child, that's something that sometimes occurs to college-savers. There are a couple of big drawbacks. The big one is that the assets become the property of the child when he or she reaches the age of majority and that will be either age 18 or 21 depending on the state where the child lives. So, that creates problems from a couple of standpoints. One is that the child has discretion over those assets and may decide not to use them for college, which if your goal was to save for college, that's not a good outcome. And the other biggie is that from a financial aid standpoint, the UGMA UTMA assets will tend to work against your child. So bear that in mind. They will tend to be less advantageous than the 529 assets or the Coverdell assets.
Glaser: Your third must-know is around asset allocation. So you've chosen the vehicle you want, but you still need to put investments in that. How do you think about saving for something that is--maybe you have less time to save for than say retirement?
Benz: Well, here again, my advice would be to not overcomplicate. So most 529 plans do have what are called age-based options where you match the date of your child's expected matriculation to the product that you buy. That can really take the mystery out of asset allocation for college, and I think it's the right choice for many people. Oftentimes these age-based programs are composed of index funds, so they are not very expensive. There oftentimes isn't a management fee for making that portfolio gradually more conservative. So there are a lot of things to like, kind of similar to target-date funds for retirement savers. The age-based options take some of the complications out of college funding.
For people who want to do their own investment selection, I think it's just important to bear in mind some asset allocation framework. And the key thing to keep in mind is that you can really run into trouble by having a too aggressive asset allocation mix too close to college. And we saw this firsthand actually in some of the age-based 529 options where some of them were way too aggressively positioned during the financial crisis. So the ones that were geared toward kids getting close to college had--not that they had too much in stocks but actually the bond allocation was overly geared toward aggressive fixed-income investment. So, I think it's important to bear that lesson in mind as you're putting together your own college savings plan.
If you have a child who is getting close to his or her teen years, I would say you'd want to have no more than 50% of that portfolio in stocks at that time. And as your child gets close to his or her junior or senior year in high school, you'd want that plan to have no more than 20% of its assets in equities. And if it looks like you're going to fall short relative to your college savings target, well, then you'll have to look at some of those other sources of funding that we talked about earlier on, whether it's financial aid, scholarships, work study, what have you. Rather than swing for the fences in terms of having a too aggressive asset allocation mix, I think it's preferable to start considering alternative sources of funding at that time.
Glaser: Christine, thanks for your thoughts today.
Benz: Thank you, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.