Saturday, April 25, 2015

How to Invest for Your Kid's Education

After posting some investing advice for my new son a few months ago, a number of readers contacted me to ask how I planned on investing on his behalf - in particular, how I planned on investing for his education.

Frankly, I didn't have a great answer to give, so I contacted my buddy Ryan Vogel, CFP® at Private Wealth Management Group to get his opinion. 

Ryan and I started our careers at Vanguard on the same day and we've remained good friends ever since. Not only is he one of the nicest guys in the business, he's also one of the most trustworthy - a valuable commodity in the finance world. Decent golfer, too. 

Rather than keep Ryan's responses* to myself, we thought it made sense to share them with you, too, as they address most of the questions I received. (This is somewhat of a U.S.-centric discussion, but non-U.S. readers should still get something out of it.)

TW: There are a lot of education savings vehicles out there for parents to consider - 529s, Education Savings Accounts, UGMA/UTMAs. Which is the best vehicle for minimizing taxes for the parents and making sure the kids get the most out of the savings plan and financial aid?

RV: While saving money on taxes is important, it should not be the primary consideration on how to invest your money for education.  The first consideration should be the goals you have for your money.  What is the purpose of this investment?  How much control do I want to retain?  Each account has their pros and cons.

529s - I deal with these the most with my clientele.

  • Tax free growth
  • No limitations based on earned income
  • Very high limits on contributions
  • Potential state tax deductions (depends on state, in PA you get a deduction for amount contributed regardless of what plan you choose).
  • 5 year averaging for gift tax avoidance
  • Can transfer money between beneficiaries that are siblings or even cousins (ideal for grandparents)
  • Can only trade once per calendar year
  • Limited investment options
  • Must be used for post-secondary education costs. 
ESAs are a better fit for saving for high school education.  However, the contribution limit is only $2,000 and there are income limitations.  This means that if you earn too much you can’t contribute.  You have a much greater choice of investment options in this type of account and the money grows tax free.

UTMAs are taxable custodial accounts.  You have complete investment flexibility but you receive no tax benefits. 

I didn’t address the financial aid part of the question because I really don’t have experience in this area.  Most of the clients I work with have incomes too high to qualify for any aid.  Also, colleges and universities have become much more detailed in vetting the finances of applicants. 

TW: Which states have the best 529 plans? How should parents evaluate them and their fund options? 

RV: Nowadays there are plenty of good options.  Ohio, Michigan, Utah, New York, Kansas, etc.  Since 529’s have trading restrictions, the best thing to focus on is costs.  What are the administrative fees?  What are the expense ratios for the underlying funds in each plan?  What funds are included in their age based option?  What are the asset allocations used in the age based options?  How about the options available other than age based?  

Then there are other aspects such as administration.  How user friendly is their website?  Is it easy to setup auto withdrawal/deposit?  Personally, I chose Ohio.  I like their aggressive age based asset allocation and the funds and administrative costs are low.  The funds are mainly Vanguard and now DFA, which I am happy about.  Their website is just OK, but I don’t go on except for when I make ad hoc contributions.  Mostly I just stick with my monthly contribution and increase the amount whenever I get a raise.

TW: What about setting up trusts for the kids' education?

RV: Setting up trusts just for education can be costly and in some cases unnecessary.  If you own a 529  you still retain control and ownership of the assets regardless of age (even though the contribution is considered a completed gift for tax purposes).  

I find education trusts are used mainly as an incentive as part of someone’s estate plan.  Basically, the trusts state that the student “go to school and graduate” or they don’t get access to an inheritance or other gift from their family.  Another aspect to keep in mind with trusts is that if you don’t have someone to act as trustee and need a corporate trustee, the trust needs to be large enough (usually at least $750k) for a corporate trustee to want to assume liability.   

TW: How should parents think about asset allocation for their kids' education funds? How should we think about making adjustments as the kids approach college?

RV: Be aggressive.  Education inflation is averaging 6%.  In order to retain purchasing power you will need to take risk.  Risk tolerance is important to consider, since you don’t want to get scared and sell at the wrong time, but investing in a stock heavy asset allocation makes sense.  

As you approach college or any goal where you know the money will be needed, you will want to become more conservative.  However, remember that you don’t need all of the money on the first day of college.  The four years (or more) will go fast, but that doesn’t mean you need to be 100% bonds and cash on the first day of school.

TW: What's the best type of account to use if I just want to buy a few stocks for my kids to teach them about investing and help them build non-education related wealth?
RV: UTMAs are the best in this situation.  There are no investment restrictions and the money can be used for anything. Just be careful how much income is generated so as to avoid paying any “kiddie tax.”

*Please note that Ryan's answers are only highlights and are not all encompassing or to be construed as specific advice.

How do you invest for your kids' education? Please let me know in the comments section below or on Twitter @toddwenning. (I ended up going with the Ohio 529 plan and started with the Wellington Fund option. I also plan on buying him a few stocks - the subject of a future post.)

Stay patient, stay focused.



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