College Funding: Investing Versus Borrowing
If something is worth $1, would you rather pay $1.46 for it, or would you prefer
a price of $0.66? That, in a nutshell, is a choice that families must make as they
prepare to pay for the cost of college education for their children. Saving and
investing for college seems a daunting task, because the goals are so enormous.
But the alternative to saving is borrowing, which is by far the more expensive approach.
Even small savings can have a significant impact over time. Every dollar saved offsets
a dollar that otherwise would have to be borrowed. More importantly, every dollar
saved can earn additional income, which brings down the total cost.
Don’t look to your 401(k) plan or IRA. These accounts are great ways to save for
retirement, and they do permit penalty-free withdrawals to pay the costs of higher
education. However, these are not good choices for building a college fund. There
are potential tax and opportunity costs for tapping your retirement resources early.
Uncle Sam to the rescue
By far the better course is to have independent savings earmarked for education.
Happily, the federal government, in the Economic Growth and Tax Relief Reconciliation
Act of 2001 (EGTRRA), enhanced two admirable vehicles for accomplishing that goal.
The education IRA, now more fittingly titled the Coverdell Education Savings Account
(ESA), has allowed tax-free withdrawals to cover education costs since its introduction
in 1997. Its previous low $500 per student per year limit has risen to a far more
Over the course of 18 years, that change can make a huge difference in the amount
available to defray the high cost of higher education. Assuming investments made
beginning of each year and earnings compounding at 8%, you can build an $80,893
college fund rather than just $20,223 under the previous rule. Obviously, that will go a
lot farther in paying college costs. (You also can use an ESA to pay primary and
secondary school costs, but that choice shortens the time that your contributions
have to grow and compound.)
Unfortunately, not everyone can fund an ESA. Individuals’ ability to contribute
the full amount phases out between modified adjusted gross income (AGI) of $95,000
and $110,000. For joint-filing couples the phase-out range is now double those amounts,
$190,000 to $220,000.
No such limits apply to another college savings provision enhanced by the tax act.
State-sponsored “529” plans permit much higher contributions without regard to the
donor’s income. Previously, withdrawals of account earnings to cover qualifying
education expenses were taxed at the student’s tax rate, presumably lower than that
of the parents. Today, withdrawals to cover college costs may be entirely exempt
from federal taxes. In addition, educational institutions are able to offer their
own prepaid tuition plans under Section 529.
Most states now offer a 529 college funding plan to both residents and nonresidents. However, residents
may gain state tax deductions and/or exemptions with their home state’s plan. Investment
options vary from plan to plan. We’ll be pleased to help you select the plan that
best meets your objectives.
The importance of starting early
The table that follows illustrates the monthly savings needed to accumulate $100,000
over different time periods at various representative rates of return. For example,
a monthly investment of $547 dollars for ten years earning an 8% return will do
the job. In contrast, the monthly debt service on a $100,000 ten-year loan at 8%
interest comes to $1,213.
Higher projected returns reduce the amount of needed savings—if, for example, that
8% is boosted to 12% on the ten-year saving plan, the monthly payment drops by over
20%, to $435. But an even more dramatic reduction can be accomplished by saving
at 8% for 15 years instead of ten—the payment falls to a much more manageable $289.
Two things happen when the saving period is extended. First, each payment is smaller
because there are many more of them. Just as important, the early payments have
much longer to compound, to grow to meet the financial need. To illustrate the true
impact of each different saving plan, the table also includes the total of the payments
during the period. Doubling the payment period from five to ten years reduces the
payment total by roughly 20% to 30%.
Returns are important, BUT STARTING EARLY IS EVEN MORE VITAL
Monthly payments needed to save $100,000 (and total payments)
Years of saving
For someone saving for five years, increasing the rate of return by 50% decreases
the monthly payment required to get to the $100,000 goal by just over 10%. Doubling
the number of years of saving drops the payment by nearly 60%. Of course, there
are twice as many payments to make. Still, total payments fall by almost 20%.
All rates of return in this table and the accompanying article are for illustrative
purposes only and do not reflect the return of any particular investment. Past performance
is no indicator of future results.
Source: Merrill Anderson Company
If you will be eligible for the Hope and Lifetime Learning Credits, you’ll want
to plan carefully. These credits may be taken in the same year that withdrawals
from an ESA or 529 plan are used, but they may not cover the same expenses. Therefore,
you’ll need to have enough saved outside the plans to cover the expenses required
to earn the credits—$2,000 for the Hope Credit in each of the first two years and
$10,000 to qualify for a full Lifetime Learning Credit.
Getting your kids through college is one of the three largest financial challenges
that you’re likely to face—along with buying a house and securing your retirement.
It’s good to know that the federal government is committed to helping you meet the
challenge, and that we are here to help guide you to the college funding plan that will best fill