How We're Saving for College

Note: This article is part of Morningstar’s October 2014 College Planning Report Card special report. This article originally appeared June 18, 2014.

For some of us at Morningstar, working here means occasionally fielding questions from friends and family about our own thoughts on investing. Questions about where the market is headed are among the most common, with inquiries about what we're investing in being high on the list, as well.

For those of us with children, how we plan to pay for college is another easy conversation-starter. As any parent can tell you, while watching helplessly as college costs continue their steep rise, it's a daunting task no matter if your child is a newborn or old enough to drive.

With this in mind we asked several of Morningstar's in-house financial experts how they plan to take on the high costs of college for their own families. All said they use 529 college-savings plans to meet at least part of this financial challenge, though not all have had the same experiences or rationale.

Staying Close to Home
Elizabeth Collins, Morningstar's director of equity research, chose the Bronze-rated Illinois Bright Start College Savings Plan for her infant son. "I wanted to stay in-state because of the tax implications," she says. Illinois, where Morningstar has its headquarters, has one of the more generous policies for 529 state income tax deduction. State residents may deduct up to $10,000 apiece ($20,000 for joint filers) per year for contributing to a state 529 plan. And with Illinois' state income tax rate currently standing at 5%, a potential contribution of $20,000 for parents filing jointly means a $1,000 state income tax deduction.

Michael Holt, Morningstar's global head of equity and corporate credit research, says his family also uses the Illinois 529 plan as well as keeps some investments outside it. "Our primary vehicle is the 529 plan because the tax advantages are attractive," says the father of two, ages 4 and 1. "We spread our contributions (time diversification) and avoid attempts to time the market due to our long-term time horizon. We also put some additional money in stocks with durable competitive advantages (economic moats in Morningstar terms) that we plan to hold for 10-plus years."

Some of those surveyed are using 529 plans from other states. One fund analyst says she and her husband chose New York's 529 plan for their older son, age 11, because at the time they were living in a state that did not offer an income tax deduction for 529 contributions. They went with New York's plan, currently rated Bronze by Morningstar analysts, because of its well-established program and low-cost investments, she says. For their younger son, age 9, they chose Utah's Gold-rated 529 plan. Both sons' college-savings accounts are invested in Vanguard funds, she adds.

"We save several hundred dollars in each account every month through auto deposit and have done so through thick and thin, financially speaking, because we assume/fear that we won't be eligible for any financial aid when the time comes," she says.

Morningstar senior fund analyst Eric Jacobson says he also uses Utah's 529 plan for his two children while keeping some assets earmarked for college outside the plan in order to maintain flexibility. He says he chose Utah's plan because, at the time, it was among the few that offered low-priced Vanguard funds and flexibility in terms of who can use the 529 assets in case the beneficiary doesn't attend college.

One Father's Perspective on 529 Highs and Lows
Although most of the employees who responded have children who are still several years away from college, Bob Johnson, Morningstar's director of economic analysis and father of a 24-year-old daughter and 21-year-old son, shared his story of how using 529 plans turned out to be a mixed bag. "My daughter's experience was nearly perfect; my son's plan went wrong in every possible way," he says.

Both children chose what Johnson describes as "very expensive private schools" and their 529 plans were the entire source of their educational funding. (His daughter has since graduated while his son just completed his junior year.) Johnson says he started saving aggressively for his daughter in 2002, "after the market cratered in the dot-com bust and before the big rally occurred between 2003 and 2007. Then by the time the crash hit, I had moved most of her funds into a more conservative structure in anticipation of her matriculation."

Johnson estimates that his contributions to the 529 represented about half of the eventual total cost to send his daughter to college. "And amazingly, everything except maybe a couple of thousand dollars was funded by the 529," he says. "All in all, my success with the program and ease of use was a perfect poster child for 529 programs."

With his son's 529 account, however, things went very differently, he says.

"Despite starting a little earlier, my cash outlay to his 529 plan probably represented 90% of the actual cost of his college," Johnson says. "To start with, I didn't fund his plan nearly as aggressively as my daughter's. In his younger years, he didn't show a lot of interest in school, and I assumed he would go to a state school. Big mistake. He was a late bloomer and ended up picking a school more expensive than my daughter's. That meant throwing extra cash into his plan in 2006 and 2007 when the stock market was beginning to peak and his interest in a state school was flagging. So the collapse hit his account [more dramatically].

"To make matters worse," Johnson continues, "I was in a state-based plan (Illinois) for the tax benefits. It turns out the cashlike component of the balanced fund I used was invested in mortgage-related securities." 

The losses incurred by the fund eventually led to a lawsuit brought by the state of Illinois against the plan provider and a settlement that compensated investors like him for a portion of their losses.

Because of his son's decision to finish school early and last year's strong market performance, Johnson will have several "tens of thousands of dollars worth of cash left in the account, now subject to tax and penalties if I withdraw it. However, since my total return was so crummy, it might not be much of a tax."

Johnson also lamented the difficulty of using the 529 to pay for some of his son's off-campus living expenses. "I can only withdraw cash out of his account for what the school charges for a dorm room, not what he is actually spending," Johnson says. "His rent is greater than the room charge and tracking down the right comparison metric each year is a real pain. Then there is food. Have you ever tried to make an 18-year-old hang on to food receipts for each and every meal or grocery purchase? I just got done adding up 11 pages of charge card bills to figure how much I could take out of his account for food. Not fun."

Johnson's story highlights both the highs and lows of 529 plans. They can work beautifully provided that they are used well, that the plan itself is sound, and that the market cooperates. If any of these factors isn't there, problems may occur.

One Last Take
Personally, I have 529 plans for each of my two children, ages 11 and 8. Initially, I had them in the Iowa and Utah 529 plans, respectively (at the time I opened them, Morningstar did not highly rate Illinois' plan). But as the Illinois plan has improved I've rolled the assets over into our state's plan, in the process pocketing a nice tax deduction on the contribution portion of the rollovers. The determining factor for me was that the Illinois 529 plan offers many of the same low-cost Vanguard index funds as the out-of-state 529 plans do. Now I get a state income tax break on new contributions to the Illinois 529 plan, and so far I've been using that portion of our state income tax refund to add even more to my kids' 529 accounts.

At the same time, each child also has a non-529 account. For my daughter, I opened a taxable account with a portfolio consisting of a balanced fund and an international-stock fund, while for my son I opened an UTMA account so as to reduce the amount of taxes paid on gains and income. My thinking was that it would be good to have access to some of the money for precollege educational needs should they arise. And I confess that I even had concerns about saving too much in their 529 accounts and being stuck paying tax penalties on any surplus amount. Of course, after watching the cost of college continue to rise into the stratosphere since I opened those accounts, having too much money saved in a 529 now seems like the least of my college-savings worries.