Month: August 2017

Growing College Savings Fast Despite the Short Horizon

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Quiz!

What is the most powerful way to maximize the value of college savings?

  1. Include increasing amounts of bonds and cash, reaching 100% as your child reaches 18, to minimize the chance of losses due to stock declines.
  2. Maximize 529 plan contributions – while returns are unknown, tax savings are a guarantee.
  3. Allocate 100% of the savings to stocks, and be prepared to take temporary student loans in case of a stock decline during college years.
  4. Create a balanced allocation of stocks & bonds, while maximizing the tax benefits of college saving plans, including both 529 & Coverdell ESA.

Look for the answer below.

Growing College Savings Fast Despite the Short Horizon

Problem: Saving for college involves a tough combination:

  1. College costs are high and grow fast (over 5% historically), requiring the help of a fast growing investment such as stocks.
  2. The time horizon is limited and fixed at 18 years, making the volatility of a stock allocation problematic in the later years. Imagine a stock allocation in 2008 right as your child reaches college age.

Solution:

  1. Invest 100% in stocks, if you (or your advisor) can stay disciplined through tough market downturns, and as long as you have strong stock-, sector- and country-diversification. Otherwise, include as many bonds & cash as needed for you to be able to stick to your plan through declines such as 2008.
  2. Once you reach college years, if there is no major decline, you can sell from your college savings, and enjoy the high likely average growth.
  3. If there is a major decline during college, you can take a student loan. This stretches the expense and lowers your yearly cash outlay during the decline. Once the investment recovers from the decline plus extra to make up for the loan interest & the limited sales during the decline, you can pay off the loan reducing or eliminating the penalty for the decline.

Additional thoughts:

  1. Currently, college saving accounts (529 & Coverdell Education Savings Account) cannot be used for paying off student loans. To enjoy this strategy, you should limit the amount of savings in these accounts. Notes:
    1. You can still use these accounts to pay for student loans that are used for current-year expenses.
    2. A bill (H.R.529 – 529 and ABLE Account Improvement Act of 2017) was introduced in January 2017 to allow use of the account to pay for student loans, but it is just in the proposal phase.
  2. There are additional reasons to limit the use of college savings accounts, despite the tax benefits. Saving too much can happen for numerous reasons:
    1. High investment growth.
    2. Lower college costs, e.g. through proliferation of online (or partly online) programs.
    3. Getting a large scholarship.
    4. Going for a cheaper university than the parents planned for (e.g. an in-state college).
    5. Skipping college altogether, and starting a business.
  3. You can benefit from maximizing a Coverdell ESA (Coverdell Education Savings Account) before using 529, for several reasons:
    1. Nearly unlimited investment choices, just like IRAs, allowing for more optimal growth, when given to the right hands.
    2. Unlike 529, the money can be used for grade-school expenses. This can help in case of saving too much.
  4. You can benefit from avoiding 529 altogether. The Coverdell ESA account is limited to $2,000 contribution per year, which significantly reduces the risk of overshooting the saving amount, especially if (but not limited to) you end up taking temporary student loans.
  5. This plan does not get in the way of you gifting the college expenses: you can gift the loan payments. If done right, you are likely to end up with a lower cost regardless of your luck with the investments, as long as you hold onto the loans until the investments go through enough of the up years of the cycle.
  6. Another consideration: the more college years you expect, the lower the overall negative impact of declines, even without the help of temporary student loans. For example, if you have 2 children, 2 years apart, and each studies for 4 years, the expense is spread over 6 years.

Quiz Answer:

What is the most powerful way to maximize the value of your college savings?

  1. Include increasing amounts of bonds and cash, reaching 100% as your child reaches 18, to minimize the chance of losses due to stock declines.
  2. Maximize 529 plan contributions – while returns are unknown, tax savings are a guarantee.
  3. Allocate 100% of the savings to stocks, and be prepared to take temporary student loans in case of a stock decline during college years. [The Correct Answer]
  4. Create a balanced allocation of stocks & bonds, while maximizing the tax benefits of college saving plans, including both 529 & Coverdell ESA.

Explanation:

  1. While bonds and cash reduce the downside, they also limit the upside. There is a way to limit the downside without this sacrifice (see the correct answer, #3).
  2. There are two problems with this solution: (1) You can over-save, resulting in a 10% penalty on the excess + income tax on the gains on the excess, if you can’t find a family member that under-saved; (2) 529 plans have limited investment options with a drag on returns that may be greater than the entire tax benefit.
  3. This optimizes the growth combining the following: (1) fast growing stocks; (2) moderating or completely reverting downturns by spreading the withdrawals over many years, in case of a decline in college years.
  4. See #1 & #2 above.
Disclosures Including Backtested Performance Data