Having a kid is expensive! According to a publication in January, 2017 by the USDA, parents are projected to spend $233,610 to raise a child to the age of 17. This amount doesn’t include college or post-graduate educational costs. Yikes! If you factor in college tuition and expenses, that total could easily climb to $300,000 or higher. Double yikes!
About two months ago, Random Gal and I welcomed a little addition to our family. With the costs of education rising faster than inflation, we wanted to give him the best chance of graduating college debt-free (or close to debt-free). To that end, we’ve already started saving for his higher education expenses. In this post, I’ll talk about the type of savings account we chose, why we chose it, and our overall savings and investment plan.
Picking an Educational Savings Account
In a previous post, I talked about different ways to save for a child’s educational expenses. While all of the methods I discussed have their own pros and cons, we decided to go with a 529 college savings plan for a number of reasons.
- You can open an account before you have a kid. Yes, you can start saving for your little one’s education even before they are conceived. All you have to do is open an account, name yourself as the beneficiary, start saving, then change beneficiaries once you have a child. So start saving now. Better yet, go back in time a couple of years and start saving then.
- There are no annual contribution limits. With a Coverdell ESA, you’re limited to $2,000 per year. There are no contribution limits for 529 plans, although they do count toward the $14,000 annual gift tax exclusion.
- Earnings grow tax-free. With UGMA/UTMA accounts, unearned income (i.e. interest, dividends, investment income) above $2,100 are taxed at the parents’ marginal tax rate. Not so good if you’re household is in one of the higher tax brackets (which we are).
- Withdrawals are tax-free on qualified educational expenses. This ensures that junior uses his money on education and not on fast cars and fancy clothing.
Choosing a 529 Plan
There are so many plans to choose from that actually picking one can be a difficult first step. Here are some things to keep in mind when deciding which plan is right for you:
- You don’t have to participate in your home state’s 529 plan.
- Your kid doesn’t need to go to school in the same state as your plan. Funds can be used at any Section 529 eligible institution of higher education. You can check here.
- Some states offer tax incentives for its residents. For example, New York’s plan allows up to $5,000 per year ($10,000 filing jointly) to be deducted from state income taxes.
- Not all states will have the same investment options. Make sure you check out all of a plan’s associated costs and fees.
We decided to go with Vanguard’s 529 plan for a few reasons, the main one being that California’s plan doesn’t offer any tax incentives or deductions. Also, Vanguard has a few more investment options available but with similar fees and expense ratios. Finally, we already have investment accounts with Vanguard and I would much rather keep things with the same brokerage company.
Determining Our Savings Goal
In order to figure out a college savings plan for LRG, we first needed to establish our goal. Would we pay for all of his expenses? Or would we just save what we could every month and leave it at that? We decided for a hybrid approach. Using this online calculator, we estimated our target amount and monthly contributions based on the hypothetical situation where LRG goes to our alma mater. Here’s a snapshot of what our initial plan looked like:
Current tuition at our alma mater is estimated at $27,870 per year if living in off-campus housing. I ended up using the default 4% in terms of the expected increase in college costs. I also went with a 7% annual return for this calculation. Based on this, we would need to save $463 a month, which we rounded up to $500, in order to cover 100% of projected college costs. As you can see, there are a few unpredictable variables. First is the expected rise in college costs. According to The College Board, in-state tuition and fees at public four-year universities increased at an average rate of 3.5% per year above inflation between 2006-07 and 2016-17. Nobody knows how much costs will increase in the years before LRG starts college; it might rise at a faster rate or slower rate. Also, no one know what investment returns will be like going forward. The historical return for the S&P 500 with dividends reinvested is about 7% adjusted for inflation. As far as future returns, your guess is as good as mine.
So we’ll just stick with our plan of $500 per month, and whatever is in the pot when our little guy goes to college is what he’ll get. I didn’t factor in any potential financial aid because, given our household income, it’s unlikely that he would be eligible for any need-based assistance.
Once we had our projected savings goal and monthly contribution amounts, the next step was choosing our investments. The Vanguard 529 plan offers age-based as well as individual portfolios. The age-based options are similar to target date retirement funds in that the composition of the portfolio shifts from aggressive to more conservative as your child gets older. These adjustments are made for you, so it’s really a “set it and forget it” strategy. I opted to invest in individual portfolios as I’m a more hands-on DIY investor. Since junior is still 18 years away from needing this money, I wanted to start off with an aggressive, 100% equities allocation. Of the available portfolios, I narrowed them down to the following four:
- 500 Index Portfolio – tracks the S&P 500 index (ER 0.19%)
- Aggressive Growth Portfolio – holds 60% Total Stock Index and 40% Total International Index (ER 0.17%)
- Total Stock Market Portfolio – tracks the CRSP US Total Market Index (ER 0.19%)
- Total International Stock Index Portfolio – tracks the FTSE Global All Cap ex US Index (ER 0.35%)
I decided to go with the Aggressive Growth Portfolio as I wanted some exposure to international equities. 40% is a bit too high for my taste, but the Total International Index Portfolio was a bit too expensive to use in a two-fund strategy. As LRG gets older, I’ll gradually shift the holdings to a more conservative mix.
Performance So Far
I opened the account in June, 2016, or about six months before LRG was born. Since inception, I’ve seen a 7.9% return. Not spectacular, but not too bad either. It will be interesting to see how this account performs going forward. I’ll probably include this account in future quarterly updates as well.
Readers, have you started saving for your child’s educational expenses? If so, what savings plan are you using? Thoughts and comments appreciated.