Having a child can be one of the most rewarding and wonderful experiences of a person's life. However, the need to save for college can be one of the most anxiety-producing aspects of parenthood. Most parents have no clue how they are going to fund four years of a college education, which could be upwards of $200,000 per child for a private school. Most parents also wisely try to keep their children out of debt, and thus try to put money aside for college.
However, traditional strategies of saving and investing for college leave your hard-earned money at risk of serious loss, just when you need the money. If you don't think it can happen, I have seen it first hand, and I can tell you it can and it does. In this piece, I want to go through some of the tips on how to save for a college education, how to reduce your costs, and how to hopefully minimize the amount of debt that needs to be used to pay for college.
The Student Loan Crisis
Taking out money to go to school is one of only two debts with which I am okay, but only if 1) the education is in something that is in demand in the market, and will result in higher earning power than one currently has, and 2) the person is willing to live well below their means to dispose of the debt in a short period of time. If either or both of these criteria are not met, then I would advise against borrowing money to go to school, because the odds of paying it back in a reasonable amount of time is minimal.
I have written a great deal about the debt burdens on American households. There is no area of debt more restrictive to a whole generation's ability to create wealth than student loans. If you thought the $1 trillion in auto loans was bad, the amount of student loans surpasses even that. Today in America, 44 million prime age borrowers have over $1.45 trillion in student loan debt, up from last year.
So it is understandable that many parents want to reduce the level of student loans that their student has to take out. Unfortunately, the way parents go about saving for college, using traditional planning, saving and investing guidelines, is simply too risky.
Traditional College Planning Advice Is Too Risky
The argument goes something like this. Invest your money for your child's education in a 529 plan. You are contributing after tax dollars and your investments grow tax-free, also your state may give you a deduction for the amount you contribute. Sounds great, right?
Traditional college planning has parents and grandparents socking away their hard-earned money into 529 savings plans that are invested largely in 100% stock portfolios. Whether they use static or age-based programs to determine the investments, investors are subject to far more risk than they realize while you move forward on the journey to high school graduation. The investment choices in many 529s are also limited, leading to investors in some cases paying higher fees. There are 10% early withdrawal penalties, and even taxes are due, if you take the money out for a non-qualified education expense.
The greatest risk of all is that you are basing your ability to pay for college on the ups and downs of the stock market. If your student began college in 1994 and ended in 1998, you are just fine, but if they began college in 2008 what then? A child's college education is simply too important to leave to the ups and downs of the market.
Ways To Reduce Your Cost
There are many things you can do to limit the cost of college before we even start talking about how to pay for it.
1. Consider Community College
Many states offer excellent opportunities to attend community college either for free or for a reduced cost. Attending community college for two years and getting basic requirements out of the way is a wise way of minimizing the total cost of college. This is especially true of students who do not know what they want to do.
Community colleges offer students a low-cost way of trying out many different classes to focus their efforts on what they are good at and what they can sell in the marketplace once they graduate. Additionally, community colleges work with state universities all the time, making your courses easily transferable to your local state university in most cases.
2. Consider a State School
I have always said that the best-kept secret in America is the honors programs at state universities. Some of the most educated and well-rounded people I have met have not come from Ivy League schools, but rather state university honors programs.
But whether your student is an honors student or not, state universities provide an excellent education at a reduced price for in-state students. States like California, Virginia, Texas, New York, North Carolina, Georgia, Florida, and many others have excellent state universities, with outstanding honors colleges. In some states, you may even be able to attend an Ivy League university for a state college price tag.
3. Have Your Student Apply For Scholarships Like It Is Their Job
It is amazing how many scholarships are available. It is also amazing how many people get a large portion of their college cost paid for by an obscure scholarship that few knew existed from equally obscure organizations and sources. Have your student apply for as many scholarships as they can, large or small. Getting lots of small scholarships can help defray more of the cost of college. If they know what they want to do, look for industry-specific scholarships. It is amazing what you can accomplish in this area if you put in the effort.
4. Have Your Student Work
Having your student work even just 10 or 20 hours a week can help defray the cost of college. There is nothing wrong with a student getting a job. It will teach them to manage money, their time, and their studies. It can also offer the parent much-needed relief in covering the cost of school. This is doubly true if the student is attending an expensive private college.
5. Be Careful What You Study
The notion that a student is going to take out $200k in student loan debt to study a major field of study that has no marketability in the economy is simply financial suicide. It is important that students follow their interests, but they should also consider what they can do with their major once they are done studying.
STEM majors will obviously lead to many job opportunities, but if they choose a field of study that is outside this realm of knowledge, they should have a plan for how they are going to use it. If they pick a career in high demand, they will more likely be able to quickly repay their loans and begin building wealth.
Alternative Vehicles To Save For College
There are multiple ways to fund a college education, and obviously, the best way for you to go about saving is based on your specific situation, tax status, and expected college expense. Here I want to present you with two alternative methods of saving for college using the same investment strategy.
The Roth IRA
The Roth IRA is an investor's best friend in creating wealth. This is mainly because the contributions are made with after tax dollars they grow tax-free. Many are aware of the benefits of using Roth IRAs to save for retirement, but did you know you could use it for college savings as well? Parents can take withdrawals on their Roth IRAs before 59 and 1/2 without incurring a 10% penalty as long as the money is used for a qualified education expense. So Roth IRAs can double as a retirement savings vehicle and educational savings vehicle.
The Taxable Brokerage Account
Using a simple taxable brokerage account to save for college gives you maximum flexibility and if you follow a relatively passive approach, as in you do not turn over the portfolio regularly, then you will only incur taxes on your gains as you sell the investments.
My preferred method to save for college is a combination of both of these strategies. In creating wealth, asset placement is just as important as what you are investing in, which is why it is important to keep tax inefficient investments in tax advantaged accounts and leave investments that are tax advantaged to the taxable brokerage account.
A Better Strategy To Invest For College
My preferred investment to save for college is the zero coupon U.S. Treasury bond. I know my regular readers are probably surprised to read that, but it's true. Zero coupon bonds are the perfect investment, in my opinion, to save for college, but if you use my combination strategy, you want to be sure to place them in the Roth IRA. This is because while they pay no interest, the government wants their tax revenue on the interest you would have received that is being compounded for you; this is known as phantom income. Therefore, they are not tax efficient.
So another alternative for investors that want to put even more in taxable accounts is to use tax-free zero coupon bonds. These bonds work similarly to the Treasury zeroes I talk about a lot, except they are generally tax-free.
So remember how a zero works. You purchase the bond at a deep discount, and the interest is compounded for you over the term of the bond. At maturity, you get your interest and principal, and in the case of muni-bonds, it should be tax-free. Municipal zeroes are a great way to save for college and build, preserve, and even transfer wealth.
I like to keep my zeroes in retirement accounts, and any saving for college in stocks or tax-free zeroes is done in a simple taxable brokerage account earmarked for the student. If they choose not to attend college, you have more in retirement savings and investment dollars to do with as you like. No penalties or other things to worry about. Also earmarking it for the child is the better strategy rather than putting it in their name, which will affect their ability to get financial aid.
In terms of how much you should save in bonds and how much you should save in stocks, that is a personal choice. As you can guess, I am tilted more towards the bond side, with stocks making up a small portion of the account. This is primarily because zero coupon bonds allow you to know for certain what the value of the bond will be at maturity. It allows you to accurately predict what you will have available to pay for college. As you can see in the chart below, it is important to start early to give your savings time to grow.
You can also tailor the bond ladder to mature in each year you will need funds for college. This takes the guesswork out of college planning and allows parents and students to search for colleges without the stress of wondering if you can pay or how much debt you will need. My hope is you will need a minimal amount of debt, but the zeroes allow you to know what the balance will be when the bond matures.
Searching for colleges with your child or grandchild should be a fun time in the student's life, and it should be for you as well. Zeroes provide you with the confidence that your finances are not left to the whims of the market and you can set them to mature at the beginning of each year of school.
All of these tips should help you save and invest for college in a way that enables you to meet your funding goals and enjoy the process of finding the right school for your student.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor. This article does not constitute tax advice. Every investor should consult their tax advisor or CPA before acting on any information contained herein.