for College
You'll face a different set of considerations with mid-term financial goals. College is one of the most interesting investment planning issues because of the special considerations involved. We can all hope that our children will receive full or partial scholarships, or generous financial aid. But, realistically, most of us need to plan on paying for college either out of savings or with loans. And it makes more financial sense to be able to pay for it out of savings than for either you or your child to take on considerable debt. Start saving early, and time can help you foot the bill. College will be a more manageable expense if you finance it with savings that have compounded over the years (particularly if they compounded in a tax-advantaged account) than if you take on debt and pay off the loans and interest with out-of-pocket money. When you save, compounding works for you. When you borrow, it works for the lender.
Your college savings bucket will require more active monitoring and management than the others for two reasons. First, you can already figure out when you're going to need the money and roughly how much you may need. If your child is 5, it's reasonable to assume that college bills will start arriving in 13 or 14 years. You can look at tuition data now and forecast what your costs could be for a private or public college. Tuition data are available from a number of sources, including the College Board's website (www.collegeboard.org). Given this information, you'll want to keep an eye on your college-savings bucket as time goes by to make sure it is moving you toward your goal. You may have to increase your savings, for instance, if you determine you are falling short.
The second reason for actively monitoring your progress in saving for college is the relatively short time frame. Suppose you begin saving on the day your child is born. You'll probably want to start out with stocks because they are likely to offer more growth. But that growth offered by stocks is accompanied by considerable ups and downs over the short term, and you don't want to have to start using those funds for tuition during a prolonged down period. So, as your child enters her teens and college approaches, it may be prudent to shift into more conservative investments, such as a money market fund and a short-term bond fund, that emphasize preservation of capital while paying some level of income. My colleague Glenn learned this lesson the hard way when one of his children reached college age during the 2008–2009 market drop, and he had failed to adjust the child's college portfolios to a more conservative stance. It pays to pay attention.
Note that many 529 plans, discussed in more detail in the accompanying Baseline Basics, offer age-based or target enrollment portfolios. You simply select the portfolio that matches your child's current age or expected matriculation date. The portfolios are diversified among stock, bond, and cash investments; the allocation then automatically and gradually adjusts over time to a more conservative mix as your child approaches the first day of college.
Baseline Basics: Accounts for Saving for College
There are a variety of ways to save for college, and the investment vehicle that's best for friends or relatives may not be the best one for you. The trade-offs involve costs, taxes, financial control, investment choices, and the impact that the plans have on eligibility for financial aid. Here is a brief look at the three popular ways to save for college.
529 College Savings Plans are a tax-advantaged means of accumulating money to pay for college or graduate school. These plans, named for a section of the tax code, are usually sponsored by states and have emerged as the go-to accounts for many Americans. The earnings of 529 accounts are exempt from federal income and capital gains taxes so long as the money goes for qualified school expenses. You are not relegated to investing with the plan in your home state, and some states offer deductions on contributions. And there are no income limits to be eligible to use the plans. 529 plans may also be used to pay up to $10,000 in student loans. The main drawbacks of 529 plans are the overwhelming number of choices both among state plans and investment options in those plans and, in some cases, high costs of those options. The sponsoring state selects the investment manager and investment options available to you. In addition, some 529 plans layer administrative fees on top of the fees charged by the underlying mutual funds. Before investing, do some comparison shopping. The effect of 529 College Savings Plan assets on eligibility for financial aid depends on who is the named owner on the account. A 529 account held in a parent's name will cut into financial aid eligibility far less than will an account held in the student's name.
Education Savings Accounts (ESAs; formerly known as Education IRAs) are another, but less commonly used, tax-exempt investment vehicle. You can contribute up to $2,000 a year on behalf of a beneficiary under age 18, assuming that you do not exceed income limits. The funds can be withdrawn tax free to pay for qualified educational expenses at primary schools, secondary schools, colleges, and universities. Another plus: You may choose the financial provider and the investments for your ESA, so you'll have a wide array of investment options from which to choose and can seek out low-cost options. With ESAs, the main drawback is the low maximum contribution. An ESA account alone may not enable you to save enough to cover four years of college. In addition, assets in an ESA count heavily against a child's eligibility for financial aid. In financial aid calculations, ESA assets are considered to be the student's property. As a result, financial aid providers will expect that up to 25% (for college aid) or 35% (for federal aid) of the ESA will be spent for college each year.
UGMA and UTMA Accounts are custodial accounts for children established under the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act (hence the acronyms). These accounts have been around for decades. With an UGMA/UTMA, you or another adult custodian opens an account on behalf of a minor at the financial institution of your choosing and invest as much as you like.They offer fewer tax benefits than the other savings programs. For children under 14, the first $750 of annual investment income is tax-free; the next $750 is taxed at the child's tax rate; income above $1,500 is taxed at the parents' rate. All income for children 14 or older is taxed at the child's rate. Also, when the beneficiary reaches the age of majority, he or she takes control of the assets—whether to pay for college or buy a sports car. In college financial aid calculations, UGMAs/UTMAs are considered the property of the student, so aid providers will expect up to 25% (for college aid) or 35% (for federal aid) of the assets to be used for college each year.
Saving for Retirement
Personal finance experts have a rough rule of thumb about how much money you'll need in retirement. It states that to live comfortably, you'll need annual income that's at least 70% to 80% of what you were earning before you retired. This money will have to come from a combination of Social Security, pension or other workplace retirement plan, and personal investments.
People often underestimate how much they'll need in retirement savings. The retirement phase of your life will hopefully last decades, and although your investments will continue to produce returns during that period, you are likely to be drawing down your portfolio at the same time. Suppose, for example, that you plan to draw on your retirement savings for 30 years and expect to take a little more out each year so that your spending can keep up with inflation. To be able to ride out periods when the financial markets turn sour or inflation runs high, you probably should not spend more than 4% of your retirement savings in the first year. A little math shows that you'll need an initial nest egg of $500,000 if you want to be able to spend $20,000 in the first year, and to increase that amount by the rate of inflation in the ensuing years.
The 4% withdrawal rate is another common financial rule of thumb. It is grounded in academic research, but it is not foolproof. For example, if you invest too conservatively and have a longer-than-average retirement, you could run out of money. I am admittedly conservative, so, when asked, I always suggest that people consider a more conservative 3% or 3.5% rate of withdrawal to ensure that they don't
