Financing Higher Education

    How to Save (and How Not To)

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    Picture the home of a Richmond-area family. In it, a couple decides they want to start saving for their child’s college costs. They search online, “What’s the best way to save for college?” The search engine returns 333,000,000 results. The parents ask their broker, and the broker starts talking to them about cash value life insurance. Next, their neighbor mentions Roth IRAs. Completely overwhelmed, the parents do nothing.

    Valuable time slips by, during which the family’s money could be growing and compounding (compound interest is when your interest earns interest, and it’s a major component to building long-term wealth). In the meantime, everyone recognizes college has become so expensive it is extremely hard for students to work their way through school and avoid massive amounts of debt. And finally, years later, their young adult child ends up with $75,000 in student loan debt to go with her 4-year degree.

    Let’s change this story. Here is a concise overview of the savings strategies I recommend, as well as some other ways to save that I’m not crazy about.

    The Invest529 college saving plan is a simple, cost-effective way to save for higher education costs. Virginia residents may also be able to claim a tax deduction on their state income tax return for their contributions. Ask your tax preparer if this applies to you.

    You can work with a financial planner to create a custom allocation using low-cost index funds within the Invest529 plan, or you can use the target date funds. Target date funds automatically adjust your asset allocation to make your investments less risky over time. This is helpful because when your kids are young, you have time on your side. If the stock market sells off, you can wait for it to recover. However, when your child is sixteen, you have less time for your investments to recover, so you don’t want to take on as much risk. The target date fund makes this adjustment for you over time. This is not the perfect solution for all college-savers, but it’s certainly worth a look.

    There is also an FDIC-insured savings account option within the Invest529 plan that may be suitable for some individuals who are already enrolled or very close to attending college. If your kids are young, weigh the benefits of a federal guarantee on your funds, versus the risk of inflation eating away the value of your money.

    Virginia529 also offers its Prepaid529 tuition program and the CollegeAmerica program. The prepaid tuition program may make sense for some families, but not for all. You can now purchase prepaid tuition on a payment program, but even that requires a significant monthly payment. Also, the funds are limited to tuition and mandatory fees, so you can’t use the money for room and board. You may consider combining some prepaid tuition with an Invest account.

    It’s important to note – if your child does not attend an in-state public college or university, you can get your money back, plus a small rate of return. If your child attends an out-of-state school, that rate of return could be described as “very small.” Visit VA 529’s website for more details.

    The CollegeAmerica program is a broker-sold college savings plan. This means that some of the investments sold through this program pay a commission to the broker who sold them to you. If a broker suggests you participate in this program, ask what fees and commissions are associated with your purchase. It may make sense for you, or it may be wiser to use the directly sold Invest529 program.

    Now that we’ve covered the 529 plan options, what about Roth IRAs? You could use a Roth IRA to pay for some qualifying higher education expenses, but there are some drawbacks to this strategy. First, there is no state income tax deduction on your contributions. Second, although your contributions may be withdrawn tax-free, any earnings withdrawn before age 59½ are considered taxable income. Third, Roth distributions are considered as income on the FAFSA form. This may reduce any financial aid you are receiving. Finally, Roth IRAs are an awesome tool to have in retirement. If you spend that money on college, you won’t have it in retirement. Be wary of giving up tax-free compounding and future tax-free withdrawals for college costs.

    Now, let’s talk about the more dubious advice some people receive related to saving for college.

    Cash-value life insurance is sometimes touted as a sophisticated way to save for college. It’s not. It’s an expensive way to save for college. There is a reason why the primary people you see touting it are the same ones who get paid a hefty commission if you buy it.

    First, expensive sales charges and insurance fees eat into the money you have to invest. Second, according to an article published at edvisors.com, “Distributions from a cash-value life insurance policy must be reported as taxable income or untaxed income to the beneficiary on the subsequent year’s FAFSA.” So in a perverse way, actually using the cash-value life insurance may increase your college costs by reducing your eligibility for financial aid. Why? A family’s income and expected family contribution are important factors affecting financial aid.

    For our children, we are combining a very small amount of prepaid tuition with Invest529 accounts. Ask a fee-only, fiduciary financial planner what’s right for your family