We're going to help this new family get off on the right foot. They need to consider just how much college will cost, how much money to save, where to invest that money, and how certain investment vehicles will affect financial aid qualifications.
Life is totally redefined for the Ramsey family. Most new parents will tell you that their lives are changed forever with the addition of a child. And you probably know that when the second child is born, the work doesn't just double, it grows exponentially. Now imagine going from zero to three babies all at once.
"We have a whole new perspective on everything--what's meaningful, what's not. It's funny how the house seems smaller now. No matter how I planned for the birth of the triplets--Lyle, Kennedy, and Tyler--I really didn't have a clue about issues like the cost of formula and diapers," says new mom Linda. She and husband Rodney now work in shifts to care for the six-month-old triplets.
"We're trying to decide if we should use a Roth IRA or a 529 savings plan. With triplets, we know we can't afford to send the kids to a private college. But we're not quite sure what a public college education will cost. And we're a little afraid to find out," Linda says. "We've bought U.S. Savings Bonds, and the kids' grandparents have been helping by gifting us more Savings Bonds. But we wonder if there's a better way to be funding this."How Much Will College Cost?
According to the College Board, the average cost for one year's tuition at a public college was $5,132 in 2004-2005. Even if we round up to $6,000 (for books, travel, etc.), that's still quite a big difference from the annual cost of $20,000 or more for most private colleges. Perhaps a bit harder to swallow is the rate at which college costs are increasing. Public college costs increased 10.5% on average between 2004 and 2005, and have been on a steep upward trend for the past five years. For private college (2004 to 2005), costs climbed 6%. If we project the cost of public college (using an 8% growth rate) for the Ramsey children, the tab would be $300,000-plus (in future dollars). If you want to calculate the cost of college funding for your children, check out the College Cost Calculator on CollegeBoard.com
.How Much Money to Save?
The good news is Linda and Rodney already have about $3,000 per child in Savings Bonds. To fully fund public college, the Ramseys will need to save another $600 a month ($200 per child), assuming a 7% rate of return on their money.
I don't know about you, but most of us just don't have an extra $600 a month lying around to meet this kind of aggressive savings goal. It will take sacrifice and a willingness to cut costs wherever possible. (For cost-savings ideas, read "97 Ways to Cut Expenses"
.)Where to Invest the Money?
You basically have eight ways to fund college:
1. Section 529 Savings Plans
2. Section 529 Prepaid Tuition Plans
3. Coverdell Education Savings Accounts
4. UTMA/UGMA Accounts
5. Save in Parents' Name
6. Save in a Child's Trust
7. IRA Withdrawals or 401(k) Loans
8. U.S. Savings Bonds
Use the College Funding Vehicle Comparison
chart from the February issue of Morningstar Practical Finance
to compare eligibility, tax breaks, investment options, control, and financial aid implications. Costs will vary by the underlying investments in each vehicle. You can read more about the pros and cons of each plan in "A Crash Course in College Savings"
Now let's figure out what's best for the Ramsey family.
Just as you'd build your portfolio with diversification in mind, so should you plan your college-funding strategy. You may choose to use more than one of the above-mentioned types of savings vehicles. In the Ramseys' case, we can rule out saving in a child's trust because it's too costly and Section 529 prepaid tuition plans because of the negative impact on financial aid. Let's look at some of their other options:Savings Bonds
It's likely that the Ramseys' income will be too high for them to get a tax break on
Savings Bond interest. (See the College Funding Vehicle Comparison
chart for limitations.) Although they should continue to hold their current bonds, let's look at other vehicles for future savings.Roth IRA vs. 529 College Savings Plans
Linda wants to know more about Roth IRAs and 529 savings plans. Since this family may be eligible for financial aid, we need to examine the impact of these options on financial aid formulas.
529 savings plans are considered to be owned by the contributor--in this case that would be the parents (or potentially the grandparents--see the College Funding Vehicle Comparison
chart). If the parent owns the plan, only 5.6% of the assets are tapped in the formula versus up to 35% for the child. 529 savings plan withdrawals are not counted in the income portion of the formulas. Other advantages include no earnings limits for donors and potential state and gift tax breaks. Disadvantages may include higher expenses, limited investment choice, and limitations on changing investment options.
Contrast this with the Roth IRA. You won't have a problem tapping a Roth because aftertax contributions can be withdrawn at any time without penalty. Parents' retirement accounts are not counted as assets in financial aid formulas. That may seem like quite an advantage, but unfortunately when you withdraw assets from a Roth IRA, they can be counted (up to 50%) as income in the formula. That's the big disadvantage of using a Roth IRA as a college funding vehicle. Because this family anticipates receiving financial aid, a 529 savings plan makes more sense than using the Roth IRA.Coverdell Education Savings Accounts
Although most people know Coverdells can be tapped for college costs, they may not realize Coverdells can also be used for private grade school or high school costs. According to Linda, it's possible the Ramsey children may attend Catholic school. Coverdell accounts receive the same favorable financial aid treatment as 529 savings plans. Since contributions are limited to $2,000 a year per child (from all donors), most people use Coverdells in addition to other plans.UTMA/UGMA vs. Saving in the Parents' Name
Since we are trying to minimize holding assets in the name of the children for financial aid eligibility, let's rule out UTMA/UGMA accounts for the Ramseys. But saving a portion in the parents' accounts should be considered. While there won't be any tax breaks, the parents will retain control of the money. And parental assets are only tapped at 5.6% in the financial aid formulas.Investment Specifics
Once you've decided which vehicles to use, you have to narrow down specific investments:
Research 529 plans at Morningstar.com
. Carefully examine fees and investment options. For example, the Nebraska plan has a good selection of mutual funds including PIMCO, Vanguard, Fidelity, and T. Rowe Price. To continue our example, the Ramseys could invest 75% in Vanguard Total Stock Market Index and 25% in Vanguard Short-Term Bond Index . This will give them a balanced portfolio with an emphasis on growth. The shorter-maturity bond fund should weather interest-rate hikes better than longer-term bond funds. While the Ramseys' contributions may increase over time, they can start by contributing $100 a month for each child. They can set up automatic withdrawals from their checking account directly into the 529. They can also contribute larger amounts from time to time when they receive additional cash inflows, such as bonuses.
Coverdell accounts can be opened just about anywhere. List the parent as owner, not the child. One investment possibility is a fund of funds like Vanguard LifeStrategy Growth
. Buying this one fund gives you broad diversification.
For as little as $50 a month, the parents can start an automatic investment plan in a fund like T. Rowe Price Personal Strategy Balanced
. This fund can be earmarked for college funding while being held in a joint account.Summary of Plans to Fund for the Ramsey Children
The Ramseys' strategy includes investing in several plans:
1. $100 per month in three 529 savings plans
2. $50 per month in the parents' joint account
3. $2,000 per year per child in Coverdell Education Savings Accounts (hopefully the grandparents can help here)
4. Continuing to hold $3,000 of U.S. Savings Bonds per child
If the Ramseys can also contribute a little more each year through bonuses or other cash inflows, they should be able to afford public college for all of their kids.A version of this article appeared in the February 2005 issue ofMorningstar Practical Finance