Saving for College

Update 12/20/2017: Coverdells are being phased out by the tax overhaul and effectively replaced through enhancements to 529s. I am leaving the Coverdell ESA section intact for reference purposes. Updates in italics.

 

529

The 529 plan also offers tax-free growth and is the most widely used way to save for college and now private school K-12. An individual can contribute up to $14,000 per year without reporting contributions to the IRS for lifetime gift tax tracking. It is a common misconception that you can only contribute up to $14,000 per parent per year. That is not true. You can Superfund your child’s 529 by contributing 5 years’ worth up front. This means each parent can contribute $70,000 in one year, and then no more contributions for the next 5 years.

With the new tax bill that just passed the House and Senate, you can spend $10,000 per year from a 529 plan on K-12 private school. This is effectively better than and replaces the old Coverdell ESA option which was limited to $2,000 per year contribution (see below). This means the 529 plan is now the de facto education savings account. The tax bill includes a provision to allow you to roll an existing Coverdell ESA into your 529 plan. I will be doing this as soon as my brokerages support it. When TD Ameritrade is equipped to let me roll over my ESA to Vanguard, I will write a follow-up piece about the process.

If your child is young and if you can afford it, it’s not a bad idea to try to save as much as you possibly can early and then just forget about it and let it grow. A couple can Superfund their 529(s) and then realistically not worry about education savings ever again. If you can superfund, how much should you save? Tuition tends to grow faster than inflation, but I personally think this will level off. In any case, you should be safe by looking at the average annual tuition in your state, multiply by 4 or 5 years, and try to save that amount ASAP. If your child is young, odds are your 529 will grow faster than tuition cost increases and you’ll be all set.

If Superfunding is not realistic, here is what $4,000 per year for 15 years looks like with the same investment portfolio – that’s $333/mo, like the car payment you no longer have.

60-20-20-4000py

After shopping all the different brokerages that offer 529 plans, my favorite is Vanguard. Don’t worry about how the plan is sponsored by the state of Nevada. You don’t have to be a Nevada resident and you don’t have to send your kid to a Nevada school.

I like Vanguard’s offering because they are low cost and they keep it simple. Many other brokers I looked at for 529s have high fee mutual funds that the trustees should be ashamed of.

You can choose between Aggressive, Moderate, or Conservative allocations. If you want, you can also pick from many individual investments. I prefer their age-based options. Personally, I would say their conservative allocation is too conservative for my tastes. I like their moderate and aggressive portfolios. Even the aggressive portfolio gets pretty conservative in the later years.

 

Coverdell ESA

I am starting with the Coverdell ESA (education savings account) because this is the lesser known account for saving for education. The Coverdell allows for tax-free growth and you pay no taxes on gains as long as the money is spent for education.

The Coverdell ESA allows you to save $2,000 per year in a brokerage account for a designated beneficiary, such as your child. Unlike the 529 plan, the $2,000 cap is for the account and the beneficiary. In other words, you and your spouse may not contribute $2,000 each for a total of $4,000. The cap is $2,000. You also can’t contribute any more funds once the beneficiary is 18 unless they have special needs.

Why use a Coverdell then? The Coverdell ESA can also be spent on private school K-12. 529 plans can’t be spent on K-12 private school.

While $2,000 per year may not sound like much and you may not plan on sending your child to private school, consider this:

What if your child is brilliant? What if your public school turns out to not be as good as you hoped? What if there are problems with other students? What if your child has learning disabilities or is injured and loses their vision or hearing? Maybe you end up needing to go the private school route even though you didn’t plan to.

Maybe you plan on going to private school anyway but scoff at the $2,000 per year limit. What if you lose your job? You’ll probably get another one, but what if you can’t make tuition or the job you get doesn’t pay as much. Wouldn’t it be nice to have backup savings?

By the way, $2,000 per year can grow to be quite large. Here is a Monte Carlo of $2,000 per year in a 60/40 US Stock/Long Term Bond portfolio over 15 years. Wouldn’t it be nice to have this on hand to cover some tuition checks? Worst case, you still have enough saved to pay for a lot (or all) of college tuition. You can replicate this sample portfolio with 60% VTI (Vanguard Total Stock Market) and 40% BLV (Vanguard Long-Term Bonds).

60-20-20-2000py

I chose to use TD Ameritrade for our ESA because they have several commission-free ETFs, including VTI and BLV (update: TDA no longer supports Vanguard funds, but they have other commission-free options available).

They also have a Portfolio Builder tool where you can set your target allocation, so it only takes a few clicks to rebalance after your new contribution. Each year when I write my $2,000 check to deposit on January 1st, I just use the Portfolio Builder to set the buy orders to automatically balance the portfolio using the new cash and I am done. No need to even look at the account again that year. Ignore it and let it grow.

Bond weighting all comes down to when you think you may need the money. In the case of the Coverdell, the horizon could be as soon as a few years due to possible private school use and probably no longer than ~20 years out. In that case, I do want to reduce the risk of a market crash tanking the value of the account. I want the money to be there if the economy really hits a rough patch so I am less risky.

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