Monday, January 18, 2016

Saving for College

While walking along the shores of a beautiful island in the Mediterranean with my wife recently, we spent our time talking about what all people talk about in similar situations. Budgeting! Ok, so maybe we're a bit nerdier that most other couples, but our specific conversation focused around how to budget additional income I would shortly be receiving. I got a raise at work that comes out to almost $1,000 a month extra take home pay, and we wanted to make sure we put it to good use and didn't get caught up in lifestyle inflation.

One of the things we decided to do with the extra income is to begin saving for our kids college. Our children are all young and none have started school yet, so now is the best time to start saving in order to have compound interest work in our favor.

We've gone back and forth on whether to set up a college savings account at all, which is probably why it's taken so long to open an account. My wife worked hard, saved, and was able to graduate with her Bachelor's degree with no debt and no assistance from her parents. I received limited assistance from my parents for my first year or so of college and then paid the rest of my way through undergrad, racking up some student loans that we quickly paid off (once we got serious about debt elimination). I also made it through a much more expensive graduate degree with no student loans, no scholarships, and no assistance from my family (just tremendous support from my wife). I've always felt that my kids should pay their way when in college, but I also don't want money (or the lack thereof) to be a limiting factor in deciding whether or where to go to college.

When saving for college, there are few different ways to do so. Below I'll outline the different options we considered and then let you know what we ultimately decided to do.

Option 1: Education IRA (AKA Coverdell, ESA)

  • An education IRA can be funded with up to $2,000 of after-tax contributions per year and growth is tax free so long as withdrawals are used to pay for education expenses.

  • One unique advantage of an Education IRA is that they can be used for private school tuition, prior to college. We aren't planning to enroll our children in private school, so this advantage didn't matter to us.

  • One disadvantage for us was that none of the financial institutions we already use offer the Education IRA as a type of account. In order to open one, we'd have to establish a new relationship with another financial institution.

    • When I worked as a financial advisor, my company didn't offer Education IRA's for two reasons. First, we offered 529 accounts, which provide a very similar benefit. Secondly, Education IRA's aren't big money makers for the financial institutions or brokers that offer them. Since only $2,000 per year can be deposited, even if you maxed out an account every year from the day your child is born and it earns 10% per year, the balance won't ever exceed $100,000 before it begins being drawn down.

    • In my experience, financial institutions that do offer Education IRA's are likely to charge much higher fees and commissions and/or have limited investment options. I recently talked to a co-worker who maxed out Education IRA's for his son for 10 years at his local bank. His only investment options were to have the money sit in a money market account or to invest in CD's. As a result, the account has hardly grown at all from the $20,000+ that he initially deposited and he has missed out on years of compounding at earnings rates much higher than the 1-3% he's been earning.

Option 2: 529 account

  • 529 accounts are also accounts where investments can grow tax free, so long as withdrawals are used to fund higher education expenses. This distinction from Education IRA's simply means that 529's can only be used for college, not for private K-12 education.

  • One thing that make 529s unique is that the beneficiary can be changed. This means that if you designate one of your children as the beneficiary, and for whatever reason that child doesn't use the money, you can change the beneficiary to another child. This comes in handy for families with multiple children like us, and the law also allows for changing the beneficiary to other close relatives.

  • If you're considering investing in a 529 account, I suggest you check out When you do, you'll learn that 529 plans are set up by each state, with each states 401k offering various different investment options within the account. This is similar to 401k's at work, but different in that you don't necessarily have to use the 529 for the state in which you live. Since funds in a 529 account can be used for any college in any state, the only reason you would want to use the 529 for your specific state is if your state offers some tax incentives to do so.

    • In our case, I learned from that our state offers a small state income tax deduction for contributions to the state sponsored 529. In order to get it, we'd have to make contributions through TIAA-CREF, the plan provider our state has selected.

Option 3: General Investment Account

  • One option we strongly considered was to simply set up an account that we would earmark for college related expenses, but that wouldn't be a tax advantaged account. We liked the idea of not being penalized for using money for things besides college, and that our investment options wouldn't be limited.

  • When going this route, we would have to decide whether we would keep the money in our own names or in the names of the kids. The upside to putting money in the kids names is that they would get some level of tax free earnings, but the downside is that once money is in the account it is considered an irrevocable gift and once they are adults we would be legally obligated to hand it over to them, regardless of their maturity level or plans for higher education.

One final option that we did not consider was pre-paid tuition. I'll admit I'm not an expert in the types of pre-paid tuition programs that exist, but I feel I know enough about them that I knew they weren't what we were after.

What We Actually Did:

After evaluating our options, what we ultimately decided to do was to open a 529 account. However, rather than open an account with TIAA-CREF (an institution we don't already have accounts with), we opened a 529 for another state that our main financial institution sponsors. We won't be getting the state income tax deduction but would rather have the account with an institution we already have a relationship with, especially since we don't know how long we'll be living here.

Although we have three children, we only opened one account. Our plan is to fund the account with enough to cover the entire amount we're willing to contribute to all of their educations in one account and to change the beneficiary as needed. Down the road, if we need to create separate accounts, we can do so, but for now this is sufficient and clean. This also makes sense because we would invest the funds the same way regardless of the child. Since I don't subscribe to investing in an 'age-based' approach that gradually gets more conservative over time, I invested the funds 100% in stocks. We've had a rocky start to the year, but this small account is benefiting from regular monthly contributions buying in a lower levels than where it started.

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