Begin with an aggressive strategy, and switch to a more
conservative strategy when college comes closer. Choose your
investments according to the number of years until enrollment and your
tolerance for risk. For example, you might
start with high yield high risk
investments when the child is young, and gradually shift the college savings
to lower risk investments as college approaches. This can be either
through a change in the asset allocation, or a change in the nature of
the securities in which you invest.
When your child is young, you can afford to pursue investments that
involve a little more risk but which promise a potentially greater
return, since you have time to recover from mistakes and weather
market downturns. (Since such investments are also less liquid, this
will help you avoid the temptation to use the money for other bills.)
When college approaches, however, you need to have the
money in safer, more liquid form. You don't want to be forced to sell
your investments at a loss, should the market drop, just because you
need the money to pay for tuition. The choice of when to sell should
be based on your evaluation of the performance of the investments, and
not based on external factors.
(Some families stick with low risk
investments from the beginning because they don't want to deal with
the complexity and stress that accompanies high risk investments. But
given that
tuition rates increase at about twice the inflation rate,
you'll need to earn at least 7% to 8%
after taxes in order to keep up with increases in college costs.)
If the stock market plummets when the child is young, the percentage
losses might be high, but the dollar losses are relatively
small. That's because the family most likely has not yet saved a lot
of money in the college savings plan. On the other hand, when the
student is about to enroll in college or is already in college, there
is much more money at risk and much less time to recover from
losses. You should plan for the possibility of losses, since the stock
market has historically had a big drop at least once a decade. Even so,
overall returns on investment tend to higher than other savings
vehicles if you have long enough of an investment timeframe.
Thus a good overall strategy is to have a mixture of high and low risk
investments and to change the proportion as college approaches, with
an aggressive strategy when the child is young and a more conservative
strategy when college is just around the corner.
- When the baby is born, put 75% of the money in high risk
investments and 25% is low risk investments. (Age 1-5)
- When the child enters the 1st grade, put
50% of the money in high risk investments and 50% in low risk
investments. (Age 6-10)
- When the child starts the 7th grade, put 25% of the money
in high risk investments and 75% in low risk investments. (Age 11-15)
- When the
child reaches the middle of the junior year in high school, put
almost all of the money in low risk investments. It is important to
realize any capital gains by December 31 of the junior year in order
to not have them count as income during the financial aid need
analysis.
Note that if the investments are in a 529 college savings plan as
opposed to a taxable brokerage account capital gains within the plan
do not affect aid eligibility.
(Age 15-18)
Many state section 529 college savings plans offer age-based asset
allocation portfolios motivated by such considerations. Such
portfolios base their asset allocation according to either the age of
the child or the number of years until matriculation. They tend to
divide the ages into four to seven age ranges. A plan with four age
ranges will switch the asset allocation in 25% chunks like the example
given above. A plan with five age ranges will use 20% chunks, and one with
six or seven age ranges will use 15% chunks. Some plans offer both a
regular age-based portfolio and a conservative age-based portfolio,
where the conservative portfolio starts off with moderate risk
investments instead of more aggressive investments. About two-thirds
of families invested in 529 college savings plans use some form of an
age-based asset allocation plans.
Another possibility is a particularly aggressive asset allocation
strategy for a family with a newborn. This strategy starts with
100% of the investment in higher risk investments, such as a S&P 500
fund or a total stock market fund, and waits until the child reaches
junior high school (7th grade, age 11) to begin shifting to lower risk
investments at a rate of 20% per year. It changes the trajectory of
the asset allocation curve to sustain a high risk, high return
allocation for a longer period, recognizing that families who start
saving sooner have more time to recover from market downturns than
families who start saving when the child enters high school. It
strikes a different balance between the need to lock in savings and
the need to have a higher return on investment. None of the state 529
plans offer such an asset allocation strategy, so the parent would
need to manage it themselves by choosing different percentages of the
funds available in the plan.
To illustrate how such an aggressive strategy increases returns,
suppose that the high risk investment has a 10% return on investment,
while the low risk investment has a 4% return. Assuming annual
contributions of $2,500, the typical moderate-risk asset allocation
strategy will yield $76,349 after 18 years, the equivalent of a 5.88%
return on investment. In contrast, the aggressive asset allocation
strategy will yield $88,397 after 18 years, the equivalent of a 7.41%
return on investment. The risk of the more aggressive strategy is that
it is more likely to suffer if there is a market downturn that affects
only the high risk investment. For example, if there is a 20% drop in
the high risk fund at age 9 instead of a 10% increase, the two asset
allocation strategies will yield $64,268 and $60,427. So instead of
having a $12,048 advantage, the more aggressive strategy has a $3,841
loss. Note that both of these strategies are much less
aggressive than a strategy which uses 100% equities for all 18 years.
An even more aggressive strategy involves stretching out the switch
from high risk to low risk investments through the middle of the
college years instead of completing it in the junior year in high
school. This takes advantage of the tax-free status of a 529
plan longer and allows for greater long-term appreciation. It is,
however, best for families that will not qualify for financial aid,
since the 529 plan will still count as a parent asset if not fully
distributed to pay for college costs during the freshman year. On the
other hand, even middle income families can benefit from this approach
if they seek to maximize the benefit from the Hope Scholarship and
Lifetime Learning tax credits.
Save in tax-advantaged savings vehicles. Section 529
plans offer many tax advantages. They allow your
money to grow in a tax-deferred fashion, and qualified withdrawals are
exempt from Federal income tax. Many states also exempt section 529
plans from state income tax, and may even give you a tax deduction for
your contributions.
If you are nervous about investing in stocks and bonds, and just want
to preserve the principal while earning a modest amount of income, you
should seriously consider using a section 529 college savings plan or
a section 529 prepaid tuition plan. Most section 529 college savings
plans offer a money market fund or a protected principal fund, and
some even have a guaranteed option which protects the principal and
guarantees a minimum rate of return (typically at least 3%). Section
529 prepaid tuition plans allow you to lock in future tuition rates at
today's prices, and are typically guaranteed by the full faith and
credit of the state. Another option is the CollegeSure CD from College
Savings Bank, which bases its interest rate on an index of the annual
increases in college tuition rates.
Too many parents use taxable savings accounts and CDs as their primary
college savings vehicle, letting taxes diminish the return on
investment.
Don't plan on tapping into your IRA to pay for college
expenses. Although you can do so without paying a 10% penalty if the
money is used for qualified tuition expenses, you will still be paying
income tax on the withdrawal. Using your IRA will also limit your
ability to take advantage of the tax credits for education (Hope
Scholarship and Lifetime Learning) and the education tax
deductions.
