|Jonas Max Ferris|
Jonas Max Ferris: The short answer is yes — saving now makes paying for anything later easier because time works to your advantage when saving. Save $1 today, and in ten years you'll have about $2.
The above math is a bit simplistic, because in ten years a dollar will only be worth about $0.78 because of inflation. It will be about as easy to come up with $1.28 in ten years as it will be to put aside $1 today — inflation means you'll be earning about 28% more in ten years without getting promoted. So why not wait to save? Problem is, college tuition will also be 28% more expensive in ten years — if not more than 28% given recent trends.
When you save, it's fairly easy to beat inflation in the long run. As the first example shows, you'll have $2 for every $1 you put aside at about a 7% annualized rate of return. Putting aside $2 in ten years will be harder than putting aside $1 today (unless you win the lottery in a few years…) because you probably won't be earning twice as much money.
I get worried when I hear “small amount” in your question. Don't think the magic of compounding will solve all future woes. Earning 7% a year will be difficult going forward. 7% may be the high end of the likely range of your future returns. You'll still need to save aggressively each year along the way. Expect to have to save an entire year's tuition along the way. Growth of your savings account plus your daughter's student loans should carry your daughter through and help leave her with a manageable debt load at graduation.
One pitfall: don't save the money in your daughter's name — it could make qualifying for student aid (not just loans which almost anyone can get, but actual grants) difficult. This is the one case where saving now will mean your daughter will have to borrow more in the future!
Question: My neighbor's son is going into his second year of college. She told me that the best way they saved up for tuition by concentrating on a single stock or sector. Do you think that's the right way to go? Or should I build a diverse portfolio with a stock/bond mix?
Jonas Max Ferris: Your neighbor is dispensing some pretty lousy advice. If you had a neighbor who didn't save for their son's college tuition, but had a very lucky weekend in Las Vegas where they parlayed $1,000 into room and board for a four year private college, would you listen to them if they said that was the best way to save up for college — getting lucky gambling?
While you have a shot at bigger winnings the more concentrated your investment — one stock being at the far extreme of concentrated portfolios — you have an equally good shot of having no money at all for school.
While Warren Buffet, the great investor, pokes fun at diversification, the drag of diversification also leads to more predictable returns.
Imagine having to tell your son (when all his friends are applying to college), “Unfortunately our hot Ethanol stock crashed when gas plummeted back below $2.00 a gallon. But look on the bright side — people are driving more and there are many jobs at gas stations!”
Build a more diverse portfolio and plan on saving aggressively to reach your goals — don't gamble with a smaller account.
A good way to go is a low-fee, diversified “fund of funds” that ages with your son. Such a mutual fund is made up of other stock and bond funds and is a complete diversified portfolio in one stop. Some of these funds are know as “lifestyle” or “target” funds because they get more conservative as time goes by (more cash and bonds, less stocks) as opposed to an ordinary balanced fund (which owns bonds and stocks) in about the same ratio.
Normally such funds are used to save for retirement, but from a financial planning point of view, your son is “retiring” when he goes off to college in the sense that you need to access the portfolio to pay for school. You can't handle a 50% hit right before the tuition is due, so a portfolio that gets conservative at that point is a good move.
Vanguard has a series of funds called “Target Retirement,” each one with a year associated with when you expect to retire. If your son is going to college in about 10 years, go with the Vanguard Target Retirement 2015 (VTXVX). There are Target 2010, 2015, 2020 an on all the way up to 2050 (stepping up by 5 years between funds). These funds are dirt cheap, you can invest with $3,000, and make small contributions along the way — even get on an automatic investing plan. Check out vanguard.com or call 800-997-2798. Other companies like T. Rowe Price (T. Rowe Price Retirement 2015) and Fidelity (Fidelity Freedom 2015) have similar fund lineups, but the low fees at Vanguard help with asset allocation type funds.
Question: My two children, both under the age of 10, are both invested in stock funds. Do you think that their college savings should be in cash and bonds by the time they are in high school?
Jonas Max Ferris: I think a portfolio should get more conservative as your kids near college age. Please read the last part of the above question for more on this issue, and investment ideas.
Question: What is a 529 savings plan? Are there a right and a wrong plan to choose?
Jonas Max Ferris: 529 plans are yet another tax favorable ways to save for something the government says is good — in this case college. We've got Traditional deductible IRAs, Roth IRAs, 401(k)s, 403(b)s, SEP-IRAs, Rollover IRAs, Coverdale Education Savings Accounts, Health Savings Accounts; the list goes on and on. We'd probably be better off with lower taxes and fewer ways to avoid those taxes, but I'm getting off the subject.
529 plans are like IRAs for college. They were created as a way to exempt the growth in a savings account from taxes — both along the way and on withdrawal — as long as the proceeds are used for higher education (which includes books and computers as well as tuition). They are similar to a ROTH IRA in that contributions are generally not deductible (unlike 401(k)s and traditional IRAs), but withdrawals are generally tax-free.
The trouble is, 529s are driven by state rules, so each is a little bit different. You'll have to read quite a bit to determine which plan is best for you (it may not be your own state plan) but here are some guidelines:
• Go direct sold — some plans are designed to be sold by brokers and have sales loads — DO not pay loads to buy funds in a plan, you'll do away with what little benefit you get in tax avoidance.
• Go cheap — find a state with the cheapest funds available. I like Vanguards 529 plan (a Nevada plan, but anyone can get in)
• Check your state perks first — Some states allow you a small deduction on your state taxes if you invest in their plan. This varies state by state, but is worth checking, as these perks are most important.
Question: As a parent, do you think I should tap into my own IRA to pay for my son's college?
Jonas Max Ferris: This question is half financial planning, half parenting philosophy. At best I'll be half right.
Don't tap your IRA (individual retirement account) or your 401(k). While the government generally waives the early withdrawal penalty for tapping your traditional or ROTH IRA, you'll still have to pay income tax on the withdrawal (assuming you're tapping into gains not contributions that went into your ROTH). Considering your ROTH withdrawals would be totally tax free if you wait until retirement, this is a bad move. Considering IRA withdrawals are income and could make it harder to get financial aid — such a move is doubly dumb.
IRA contribution limits are low as it is; don't fritter away these perks for non-retirement spending.
Don't risk your retirement to pick up the tab on your son's college bill. Your son should bear some of the burden by taking out student loans. You contribution should be from savings put aside specifically for these college expenses. If you didn't save enough try paying a certain amount each year while your son is in school and cutting back on your own expenditures — I'm for saving your retirement, not for your current standard of living, that is negotiable to help educate your child.