You’ve heard all the bleak stories. Tuition at private universities is now so high that only the superrich and families willing to bury themselves in debt can afford it. Even parents who set their sights on a lower-cost state school can barely manage to save enough to keep pace with college-cost inflation. As they say, the hurrieder you go, the behinder you get.
Well, it’s time to re-evaluate. The long U.S. economic boom has made postsecondary education more affordable than it’s been in a long time. Jobs are plentiful, and compensation is up. And while rising college costs continue to outpace the increase in consumer prices generally, tuition inflation has cooled to a more manageable 4.5 percent–about half the pace of the early 1990s.
The stock market, meanwhile, has climbed from one record high to the next. The Standard & Poor’s 500 Index, a broad market benchmark, recorded its fifth consecutive year of extraordinary growth in 1999, and stock mutual funds that track the index have earned 17.9 percent compounded over the past 15 years. If you had managed to start investing $200 a month in a stock index fund when your child was a toddler, today your investment would be worth nearly $143,000 before taxes–about the cost of four years’ tuition, room, and board at the priciest Ivy League university today.
If your college-savings plan is still stuck in dry dock, this report can help. We’ll introduce you to proven techniques that can add ballast to your college savings now, suggest how you can reduce your tax liability as you build your assets, and help keep you from running aground on shoals that could reduce your eligibility for financial aid.
STEADY AS SHE GOES
Whether your future college enrollee is still in diapers or already in high school, it’s unrealistic to anticipate that future investment returns will match the exceptional performance of the 1990s bull market. Tracking the past 73 years of market performance, the Chicago-based investment research firm Ibbotson Associates found that stock prices have risen an average of just under 12 percent annually; long-term U.S. Treasury bonds have returned an annual average of 5.3 percent.
Because those returns can fluctuate wildly from year to year, you’ll want to invest in a combination of more-volatile stocks and steadier bonds and money-market funds in proportions you adjust over time to help you ride out the markets’ gyrations. That’s best accomplished by following a disciplined three-phase investment strategy. In phase one, running roughly from the time your child is a preschooler until he or she completes sixth grade, consider putting as much of the money as you can afford to earmark for college in a stock mutual fund–preferably a low-cost index fund whose performance will mirror that of the equity markets as a whole. As your child advances from middle school to high school, start redirecting more of your new savings toward fixed-income securities–phase two of the plan. Finally, in phase three, when your teenager closes in on high-school graduation and the great ivy wall looms, gradually convert your longer-term stock and bond investments into shorter-term, low-risk, fixed-income investments.
Breaking the chore of saving for college into manageable monthly installments will be gentler on your household budget and help keep you on course toward your ultimate goal. The sooner you get started, the more manageable the job will be–though it will still be a formidable task. Even if tuition inflation were to remain at today’s relatively moderate rate, parents of a child born this year would have to start setting aside more than $150 a month (invested 85 percent in a stock mutual fund and 15 percent in bonds earning historical rates of return) to accumulate enough to afford the average tuition, room, and board at a state university. Have your eyes set on the Ivy League? Plan on saving four times as much, or about $600 per month.
Those numbers can be intimidating, but even a modest beginning can yield big dividends. For example, had you put aside just $50 a month for the past 18 years (about what many households spend for cable TV), equally divided between a stock fund and a bond fund, your college savings would have grown to about $26,000. That’s nearly enough to cover the average cost of three years at a public university at today’s prices.
If you haven’t seriously begun investing for college by the time your teenager enters high school, you cannot realistically expect to save everything you’ll need by the time your child meets the bursar. Absent a windfall inheritance or help from a wealthy relative, a bit of financial triage is in order. Here’s where to start:
Find smart ways to boost saving. Cut back spending where you can to free up more of your income for savings. But don’t become so fixated on saving for college that you shortchange your equally urgent responsibility to invest for your own retirement.
If you will reach age 59% while your child is still in college, you may be able to take advantage of tax-advantaged retirement plans to accomplish both objectives. Money you set aside in a Roth IRA accumulates tax-free and can be withdrawn without penalty if you’ve held the funds in the account for at least five years. Even younger parents can tap Roth IRA savings to meet college costs. They can withdraw their original contributions free of taxes and penalties, provided the money has been in the Roth IRA for a minimum of five years. (You qualify to contribute to a Roth IRA if your annual income falls below $160,000 for a married couple filing jointly (or below $110,000 for an individual filer).
You can accomplish much the same goal through your 401(k) plan at work. Provided you are already maxing out your pretax contributions and your employer’s plan permits it, ask the payroll department to withhold additional after-tax income from your paycheck and add it to your retirement account. There it will compound tax-deferred until you withdraw those specially earmarked funds to meet college tuition bills. If you’ve reached age 59, there will be no early-withdrawal penalties, and only the compounded earnings will be taxed at your personal tax rates.
Be realistic about what you can afford. Colleges and universities award some $60 billion in financial aid annually. The distribution of those funds is determined by complex formulas that weigh a family’s income and savings to determine a prospective student’s need–and what proportion of the total cost the family can be expected to pay out of its own resources, a figure the schools euphemistically call the “expected contribution.” The formulas expect high-earning parents with little saved to meet much of the “contribution” out of current income. Absent special circumstances such as high medical expenses, you shouldn’t count on qualifying for need-based aid if your pretax income exceeds $75,000 and you have one child in college at a public university in your state. Parents with only one child in college attending a private university shouldn’t expect help if their total income exceeds $150,000 a year.
You can get an early read on what your tuition obligation is likely to be–and focus on schools whose costs you can manage–by consulting a current edition of a comprehensive college financial guide. One with up-to-date aid formulas is “Paying for College Without Going Broke,” by Kalman A. Chany with Geoff Martz (Random House, $18). To find out how much you could expect to pay each month if you were to bear the full cost out of current income while your child is in school, see the table at right.
KEEP A WARY EYE ON TAX SHELTERS
Money you save for college goes a lot further when it’s allowed to accumulate tax-free or tax-deferred. Changes to the federal tax laws in 1996 now make tax savings possible in a variety of ways. Here are some of the new opportunities–along with the restrictions that may limit their appeal to you:
Education IRAs. This federal program allows individuals with a household income of $160,000 or less ($110,000 for a single tax filer) to contribute up to $500 a year in after-tax income per child to an account specially earmarked for that child’s post-secondary education bills. While those tax savings can add up over time, Education IRAs come with strings attached. The funds must be used for their intended purpose by the time the beneficiary reaches age 30, or they must be transferred to another qualified family member. If the accumulated earnings are not used to pay education bills, they will be taxed at the beneficiary’s rate and subject to an additional 10 percent penalty.
State tuition plans. When the cost of college tuition was rising at double-digit annual rates in the late 1980s, several states, including Michigan, Florida, and Alabama, began offering their citizens prepaid tuition plans. Now available in 19 states, these plans guarantee that the invested funds will keep pace with tuition inflation no matter how fast college costs rise. The increase in value will be taxed at the student’s rate when the funds are used to meet education costs. Prepaid plans can offer a lot of peace of mind, but they are less attractive now that tuition inflation is tamer.
There are more appealing options available to parents in the state-sponsored tuition savings plans that have cropped up in 22 states in recent years. (Similar plans are pending in another 12 states.) Most tuition-savings plans use an age-based asset allocation model that invests a larger proportion of funds in equities when the child is young and gradually shifts to fixed-income investments as the child ages. While funds invested in these plans are not guaranteed to generate a specific rate of return, they do benefit from tax-deferred growth of earnings until the funds are withdrawn. The gains are then taxed at the student’s normally lower rate.
Before you sign up for one of these plans, study your options carefully. Some plans invest mostly in fixed-income securities whose low returns may not make the tax savings worthwhile. But if you’re unhappy with the plan’s performance after you’ve committed to the program, you cannot withdraw the funds without incurring a 10 percent penalty and paying taxes on accumulated earnings at the contributor’s personal tax rate. And because these plans are relatively new, you cannot be sure how colleges may count these savings when awarding financial aid years from now. Finally, if you do decide to fund a state-sponsored tuition-savings account or prepaid plan, no funds can be contributed to an Education IRA for that child in the same tax year.
Eligibility rules and details on how these plans work vary from state to state. For more information, contact the National Association of State Treasurers (877 277-6496; www.collegesavings.org). The web site has links to all the programs.
And if you don’t save …
Think it’s tough saving for far-off college bills when your child is young? Consider the burden you would face if you saved nothing and had to pay out of current income over the four years your child is enrolled. As this table shows, if your youngster is entering State U. this fall, expect to pay at least $753 a month for tuition, room, and board. Parents of an infant born this fall who have their eyes on an Ivy League education would shell out more than $9,300 a month if school costs rose at a 6 percent rate.