The following investment strategies provide advice on how best to invest the money you are saving for college. You may also find the easy savings tips helpful in this regard.
Investment Strategies
Start early. The best investment advice anyone can give is to start now. It is never too soon to start saving for college. Even the day the baby is born is not too soon. At 10% interest, money saved during the first year of a child’s life is worth five times as much as the same amount saved the year before the child enrolls in college.
Begin with an aggressive strategy, and switch to a more conservative strategy when college comes closer. Choose your investments according to the number of years until enrollment and your tolerance for risk. For example, you might start with high yield high risk investments when the child is young, and gradually shift the college savings to lower risk investments as college approaches. This can be either through a change in the asset allocation, or a change in the nature of the securities in which you invest.
When college approaches, however, you need to have the money in safer, more liquid form. You don’t want to be forced to sell your investments at a loss, should the market drop, just because you need the money to pay for tuition. The choice of when to sell should be based on your evaluation of the performance of the investments, and not based on external factors. (Some families stick with low risk investments from the beginning because they don’t want to deal with the complexity and stress that accompanies high risk investments. But given that tuition rates increase at about twice the inflation rate, you’ll need to earn at least 7% to 8% after taxes in order to keep up with increases in college costs.)
If the stock market plummets when the child is young, the percentage losses might be high, but the dollar losses are relatively small. That’s because the family most likely has not yet saved a lot of money in the college savings plan.
Thus a good overall strategy is to have a mixture of high and low risk investments and to change the proportion as college approaches, with an aggressive strategy when the child is young and a more conservative strategy when college is just around the corner.
When the baby is born, put 75% of the money in high risk investments and 25% is low risk investments. (Age 1-5)
When the child enters the 1st grade, put 50% of the money in high risk investments and 50% in low risk investments. (Age 6-10)
When the child starts the 7th grade, put 25% of the money in high risk investments and 75% in low risk investments. (Age 11-15)
When the child reaches the middle of the junior year in high school, put almost all of the money in low risk investments. It is important to realize any capital gains by December 31 of the junior year in order to not have them count as income during the financial aid need analysis. Note that if the investments are in a 529 college savings plan as opposed to a taxable brokerage account capital gains within the plan do not affect aid eligibility. (Age 15-18)
Many state section 529 college savings plans offer age-based asset allocation portfolios motivated by such considerations. Such portfolios base their asset allocation according to either the age of the child or the number of years until matriculation. Be aware of the risk associated with your investments.
Evaluate investment vehicles carefully before investing. Carefully evaluate all the various investment vehicles before deciding where to invest. For example, you might be told to invest in tax-free municipal bonds in order to minimize the tax bite. But you might be able to find a mutual fund that isn’t tax-exempt but which has a higher yield after taxes. Similarly, growth funds might have a investing philosophy that seeks to maximize long-term returns, but the actual returns on other types of funds might be just as good. Although life insurance and annuity products are sheltered from financial aid need analysis, using them as an investment vehicle is not your best option, since the rate of return, after subtracting fees, commissions and other loads is often very low. Likewise, some of the section 529 college savings plans have very high sales charges (as much as 5% or 6%) and expenses, while others may be very low. Setting up a trust or using the Uniform Gift to Minors Act might save you a little on taxes, but significantly reduce eligibility for financial aid. So always compare investments based on the net return after all expenses including taxes are subtracted, and consider the impact on need-based financial aid. It pays to shop around.
Remember that historical performance is no guarantee of future return, so you should choose funds based on what you think will do well in the long term, not which funds happened to do well last year.
Good resources in this area include:
US Securities and Exchange Commission: SEC Introduction to 529 Plans
National Association of Securities Dealers: NASD Smart Saving for College and Investor Alert on 529 Plans
Morningstar publishes a guide to 529 plan performance, as does Money Magazine.
Reevaluate your investments at least once a year. If you find that the assumptions behind your investment strategy are not correct or your risk tolerance has changed, you may want to change your investment allocations. Remember, you should not sell an investment just because the market is down, but instead based on how you feel the investment will do in the future.
Diversify your investments. Don’t put all your eggs in one basket. If you invest in stocks, for example, it is better to invest in mutual funds, since mutual funds spread out the risk over many stocks. This prevents a significant drop in the value of one stock from affecting your entire portfolio. You might find mutual funds which try to mimic the behavior of the market as a whole, such as the S&P 500, to be a good investment strategy. Such index funds often have lower fees. Very few managed funds outperform the indexes on a long-term basis. Likewise, you may want to invest in a mix of stocks and bonds, so that your money isn’t all in stocks, and keep some portion of the money in a money market account or savings account. You should choose approximately four to six different investments in order to minimize your downside risk.
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Save regularly. Investing a fixed amount of money at regular intervals (e.g. once a week, once a month) gets you the benefit of dollar cost averaging. a good investment technique. It also gets you in the habit of planning for your future. If possible, have it done automatically through payroll deduction or bank drafting (EFT), so that the money is taken out of your bank account before you have a chance to spend it.
Save in the parent’s name, not the child’s name. This will minimize the impact of the fund on need-based financial aid.
Save in tax-advantaged savings vehicles. Section 529 plans offer many tax advantages. They allow your money to grow in a tax-deferred fashion, and qualified withdrawals are exempt from Federal income tax. Many states also exempt section 529 plans from state income tax, and may even give you a tax deduction for your contributions.
If you are nervous about investing in stocks and bonds, and just want to preserve the principal while earning a modest amount of income, you should seriously consider using a section 529 college savings plan or a section 529 prepaid tuition plan. Most section 529 college savings plans offer a money market fund or a protected principal fund, and some even have a guaranteed option which protects the principal and guarantees a minimum rate of return (typically at least 3%). Section 529 prepaid tuition plans allow you to lock in future tuition rates at today’s prices, and are typically guaranteed by the full faith and credit of the state.
Avoid capital gains starting two years before college. When college is two years away, move most of the money into safe investments, such as FDIC insured certificates of deposit or a money market fund. This will make the investment more liquid, so that you’ll have the money available to pay the college bills. You don’t want to be forced to sell a stock at a loss in order to pay tuition. Should you realize a significant capital gain when you sell the stock during the tax year before applying for aid, not only will the financial aid formulas charge you for having an asset, but they’ll also treat the capital gains as income. You need to realize the capital gains early enough so that they don’t affect eligibility for financial aid. (If you did realize significant capital gains the tax year before applying for financial aid, ask the college’s financial aid administrator for a professional judgment review, on the grounds that the one-time capital gains is not reflective of award year income and that the formula is effectively double-counting them. Many financial aid administrators will use their authority to exclude such capital gains from base year income, if you ask politely.)
