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الخميس، 26 يناير 2017

31 Days to Financial Independence (Day 24): Investing and Saving for Education

“31 Days to Financial Independence” is an ongoing series that appears every Thursday on The Simple Dollar. You might want to start this series from the beginning!

Last time, we discussed steps that people need to take in order to use their “gap” money – the difference between their income and their spending – to begin saving for a robust retirement.

Today, we’re going to look at another major goal that many people have for their lives: saving for future educational expenses, both for their children and for themselves.

It’s the dream of many parents to save up enough money so that their children can go to a great college, yet parents often discover that achieving that goal is much harder than it seems. Is it an achievable goal? Is it even a worthwhile goal?

Many other people reach a point in their adult lives where they consider going back to school to continue their education, whether to obtain a master’s degree or to head down a new career path. Is that an achievable goal? Is it even a worthwhile goal?

Both of those matters rest upon the shoulders of a similar set of issues and questions. Is it better to save in advance for a college education? Or is it better to wait and rely on loans? Are there alternative strategies for achieving the training needed for work outside of the typical college route? How much of a child’s college education should a parent actually pay? If you’re saving for future educational expenses, how should you do that in a financially optimal way?

It’s a tangled mess of questions and matters to resolve and they end up becoming something that people put off and put off until suddenly their child is leaving for college and they’ve saved very little or until they’re standing in a career crossroads.

At those late points, the options are limited and many of the best opportunities have already been taken off the table.

Don’t let yourself wind up in that position.

Exercise #24: Planning and Saving for Education

Although there are definitely some action steps to be taken later in this exercise, much of this centers around reflecting on your own situation and figuring out whether saving for education makes any sense for you and your family. It’s not an easy “yes” or “no” question, so let’s start by untangling the knots together.

Do you think you should pay for the entirety of the college education of your children? If not, then how much should you pay for? This is a fundamental question that people need to ask themselves as they begin to drill into the question of saving for education.

Sarah and I have come to the conclusion that we’re willing to pay for a portion of our children’s education, but not for all of it. Here’s our rationale for that mindset.

On one hand, we both found it valuable for us to have some “skin in the game” during our college years, in that we understood that we had a personal financial stake in our college performance. Without that personal stake, it would have been easier for both of us to not take college seriously. We couldn’t just fail out without real personal financial consequence; it was our burden, too.

At the same time, we both recognize that college is incredibly expensive and that large student loan payments are a huge burden to overcome in your early professional years. It restricts your professional choices. It restricts your life choices. It forces you to make other financial choices that are suboptimal, like altering the decision as to when it makes financial sense to buy a house.

Our goal, then, is to pay for a portion of our children’s college educations, but not all of it. We expect them to pay for a large portion, likely a majority portion, of it themselves.

Answering this question now sets up some expectations for what you should be able to save for your child’s education. There is no “right” or “wrong” answer here. Some parents may want to pay for all of their child’s education. Some may choose to pay for most of it. Others may choose to pay for half or a little less. Some may simply want to cover just a small portion.

Why is that important? Well, US News and World Report, relying on Department of Education numbers, estimates that a four-year college degree will cost about $200,000 in 2030. If you’re planning on paying for all of it, then you need to be saving $200,000. If you’re shooting for half, that’s a $100,000 target. That’s an enormous difference, one that’s going to change your strategies for saving.

So, what’s your target? Are you going to try to pay for the whole thing? In that case, expect to be putting aside about $500 a month from birth until age 18. Are you going to pay for half of it? That’s going to be about $250 a month from birth until age 18. (This is, of course, assuming you’re investing in something that’s going to earn a 7% return).

Figure out your philosophy now, because your philosophy here directly influences how much you need to save each month.

Are you going to return to school in the future? And, if so, what might that look like? When would you go? Would it be full time, or would it be in the form of weekend and evening classes? Would your current employer be able to pay for some of the cost or would all of the expense be coming out of your pocket?

The truly important question here is whether or not additional education is in your future. Are you considering earning a higher degree to jumpstart your current career? Are you considering a career shift that will push you in a completely different direction and require a completely different degree? How likely are those things?

If those things are likely in the future, then saving for your education in an appropriate account now is a bright idea. It will save you quite a lot on your education expenses later on with no tax penalties.

The drawback, however, is that if you end up not getting an education and you don’t have anyone in your life to transfer those savings to (something we’ll get to in a minute), then you’ll get hit with an additional tax penalty when you use the money you’ve earned in that account.

So, here’s the deal: if you’re pretty certain that some form of additional education is in your future, you’re better off saving for it now in an appropriate fashion than you are waiting around. If you’re much less certain, saving up for it in an account without specific education benefits is probably a better all-around choice.

A 529 college savings plan is far and away the best vehicle to use for college savings, whether for you or for your child. If you are certain – or at least very confident – that post-secondary education is in the future for you or your child, the best tool you can use to start saving now for that future education is a 529 college savings plan.

A 529 plan is not all that different from a savings account on the outside. You deposit money into it, just like a savings account, and you can take money out later when you need it, just like a savings account.

There are a few differences, however, and two of those differences are really beneficial for education.

First of all, when you start a 529 college savings plan, you must name a beneficiary. The beneficiary is the person for whom the plan is designated to be used for in order to pay that person’s expenses. So, for example, I have three separate plans for each of my children, and in each plan, a different child is named as the beneficiary.

You can change beneficiaries among siblings without any tax consequences (and grandparents can move accounts among first cousins of the same generation), which is a real benefit for parents with several children or grandparents with lots of grandchildren. If, say, your oldest child doesn’t need their full savings, you can change the beneficiary to another child without tax consequences.

Second, while money is in a 529 account, you can designate it to be invested in stocks or bonds or real estate or other things in order to earn a better return. You can always just leave it in the form of cash and earn a steady slow trickle of interest, just like a savings account, but if you’re going to be leaving money in there for very long at all, you probably want options that offer a better return.

Third, when you withdraw money from a 529 plan for educational purposes, you don’t have to pay taxes on the investment return within that account. So, let’s say you put in $1,000 when your child was born and it grew to $3,000 by the time your child is 18. If that child takes out that money and applies it to tuition, that $2,000 in investment gains is tax free. If you save in other ways, that $2,000 is going to be taxed, eating away at your gains.

There is a drawback, however. If you take out money for non-educational purposes, you have to pay taxes on the gains, plus an additional tax penalty. What this essentially means is that you really shouldn’t put money into a 529 plan unless you’re quite confident that you’re going to be using that money for educational purposes at some point.

It’s worth noting here that grandparents, family members, and friends can contribute directly to 529 plans. This actually makes it very easy to centralize college savings and gifts intended for college savings for children.

If you or your child receives scholarships, you can make a tax free withdrawal from a 529 plan equal to the amount of that scholarship to use as you like. Let’s say, for example, that you’ve been saving up for your child, but then your child receives a National Merit Scholarship and has their tuition paid for. At that point, you can consider the option of taking some money out of the account for other expenses without any taxes at all, or else you could leave it in there for potential graduate school expenses.

Similarly, if the beneficiary dies or becomes disabled, there is no penalty for withdrawing the money. A 529 really does offer a ton of advantages when you’re saving for college, even if things don’t turn out the way you plan.

Finally, 529 plans often have special tax benefits if you open a plan in the state where you live and your state collects income tax. For example, in Iowa, if you use their College Savings Iowa 529 plan, your contributions are tax deductible if you’re an Iowa citizen paying Iowa state taxes.

Each state runs its own plan, with some variations between them. You can generally join a plan from another state if you prefer, but some states offer particular benefits for using the money from that state’s plan for education spending in that state or offer tax benefits as described above. Different states also use different investment houses on the back end of the plan. In general, however, using the 529 plan in your own state is usually perfectly appropriate if you’re unsure.

You can start saving in a 529 for your child before that child is even born. You do this by setting up a 529 plan with yourself as a beneficiary and then change that beneficiary after the child is born. However, when you change the beneficiary on the account from a parent to a child, it’s considered a gift and is subject to the usual tax rules of gifts, meaning that you need to keep the gift below the gift exclusion. In short, keep it under $13,000 and you’re fine if you’re not giving any other cash gifts that year, or keep it under $65,000 and you’re fine if you give no other gifts in the next five years.

I did this exact thing with my own children, as I started a plan for each of them before they were born and changed the beneficiary after their birth.

529 plans are usually built up through regular automatic transfers of money. When you sign up for a 529 account, the plan usually will have you set up an automatic transfer program from your checking account to that new account. That automatic transfer will take whatever amount you designate directly out of your checking and put it into the 529 account at whatever rate you designate.

So, for example, you might want to set up a $100 per month transfer (which would get you to roughly $40,000 if you start as a newborn and keep going until the child is 18), or $25 a week (which would get very similar results). You might choose to do more or do less. Once you set it up, though, it’s all automatic. You don’t have to think about it.

Automatic savings is the best way to save for any serious future goal. It takes the day-to-day decision making process out of your hands. You no longer have to decide after each paycheck whether you want to save money for that goal. You no longer have to remember it. It just happens automatically, and you have to put in effort to stop it.

Keep it simple when choosing investments. As with retirement, one area that often stymies a lot of people and keeps them from actually getting started is uncertainty about investment choices.

When you sign up for a 529 plan, you’re often bombarded with investment options. You can leave your money in cash. You can put it into stocks. You can put it into bonds. You can put it into real estate. You can even mix things up amongst all of those categories. Not only that, there are often many options within those broader categories, too.

In an effort to try to find the best option, people often get “locked up” by the sheer number of options and then fail to make any decision. They just put it off, and because of that, they fail to take advantage of the most valuable years of investing – the first ones.

This is a situation where “the perfect is the enemy of the good.” You are far better off choosing a “good” investment at random and starting now than twiddling your thumbs and putting it off and eventually finding a “better” one later.

For one, if you put it off, you miss out on contributions. Right at this very moment, you’re as far as you’ll ever be from the day you need that money, which means you have the most possible time for the power of compounding to help you earn a lot. The longer you wait, the less your investing dollars will earn because they’ll have less time to grow.

For another, within a 529, you can always change options later. If you do eventually find a “better” option, you can move that money around within your account.

If you’re unsure where to even start, almost every 529 plan has a pretty good default choice that anyone can use. It’s usually called a “target date” fund. Just figure out which year you or your beneficiary is likely to start using the money you’ve invested, then choose the “target date” fund that matches that year and put all of your money in there.

A “target date” fund automatically balances your investments for you so that you have more risk and more reward when you’re far from that date so that you can potentially earn more (with some risk), but that risk lowers as you get closer so that you don’t unexpectedly lose a lot of your balance. It’s a nice balancing act, and a “target date” fund does that for you automatically.

The perfect is the enemy of the good, and a target date fund is almost always a good option. Put your money there if you’re unsure what to do with it.

The sooner you sign up, the better off you are. The reason is simple. The sooner you sign up, the more time you have to make regular contributions to the account, so your total contributions will be higher between now and the start of college. Similarly, you’ll also have more time for those investments to grow, meaning your returns will be better, too.

For example, let’s say that you found an investment that earns 7% per year. You have a newborn child, and you’ve decided to save $100 a month. If you start right now, you have eighteen years of contributions and 18 years of growth. That $100 per month is going to grow to about $42,000.

Wait just one year, though, and that $100 a month will grow to only $38,000.

That’s right, waiting just one year on a $100 a month savings plan will cost you more than $4,000 when your child reaches college age.

The take-home point? Start saving sooner rather than later. You’ll be aided both by having more contributions in there as well as having more time for your investments to grow.

Next time, we’ll look at investing and saving for other goals, like down payments.

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