A hot-button issue this time of year that brings clients to advisors is funding their child’s college education. “The reason is just plain, old cost,” explains Susan Hirshman, managing director for JPMorgan Asset Management in New York. “College is just so much more expensive now.” In fact, the rate of increase in college costs has outpaced inflation by as much as 6% to 8% in the last decade. For the 2006-2007 academic year, the estimated cost of four years at a public college is $55,152 and the estimated cost of four years at a private college jumps to $130,886, according to The College Board (Go to www.investmentadvisor.com to see estimated future costs of college). To boot, a greater number of kids are going to college, and a significant amount of those students are living away from home and/or attending private schools, adds Hirshman. But these factors are just part of the reason why education funding is becoming more difficult. Saving habits have a lot to do with it as well, which is why even the more affluent families are having college funding issues. “There is a significant percentage of affluent people who do very well at earning money, but save nothing,” explains Hirshman. The fact is that saving for college tuition remains a top priority among families. The problem is that the priority exists more in concept than in practice.
Unrealistic and Unprepared
“It’s not that people don’t have the money,” explains Michael Conrath, VP of college savings plans at AllianceBernstein Investments. In fact, the major problem is that parents are unprepared, according to research conducted in the summer of 2006. The AllianceBernstein College Savings Crunch study surveyed 1,350 parents to understand their attitudes and behaviors related to saving for college. Recent college graduates and financial aid administrators were also interviewed. The study found that 95% of parents intended to pay some or all of their children’s college expenses, even though one-third of those parents hadn’t started saving yet, and 64% had saved less than $10,000. “It’s become a moving target,” states Conrath. “College costs are rising at a rapid rate while parents are not saving enough to begin with.”
According to Conrath, there are two major reasons why parents aren’t saving. The first is overspending. “We’re living in a consumer society and you can almost say that there’s a compulsive consumerism today among many families,” he explains. “A lot of people are spending at the expense of their kids’ future college education.” In fact, a staggering 58% of parents surveyed spent more on dining out in a given year than they saved for their kids’ education, according to the AllianceBernstein research. “If you ask parents what is the most important investment they can make, the answer is helping their children pay for college, but there’s a big gap between what their wishes are for their kids’ futures and what they’re actually doing today,” reveals Conrath.
The second reason why parents are unprepared is because they are relying too heavily on financial aid. “That’s one area where there are a lot of misconceptions,” Conrath says. More than two-thirds of parents surveyed believe that colleges will design a financial aid package that will allow them to afford paying for their kids’ education. However, financial aid officers paint a completely different picture. Nearly all financial aid administrators surveyed said parents have a false sense of security that colleges will help them cover education costs. This goes for scholarships as well. A majority of parents think their kids’ talents will guarantee them a scholarship–84% of respondents believe there are lots of scholarships that will help cover costs, and 72% believe their child has a unique or special talent that will qualify them for a scholarship. The reality is that scholarships are few and far between. “I’ve never met a parent who didn’t think their child wasn’t the smartest,” recalls Paul Donas, a registered rep for John Hancock based in New York. He counsels clients that it’s better to save more and have extra, than counting on something that may not come to fruition.
The Perfect Plan
So once you convince clients to start putting money away, how should you advise them to do so? Let’s list the ways.
529 Plans The most popular education savings vehicles and the first choice of most planning professionals are 529 plans. In fact, there is almost $100 billion in 529 savings plans now, says Conrath. Susan Black, director of financial planning at eMoney Advisor, a wealth planning technology firm, agrees. “Use a 529 plan and get as close as you can to pay for the education,” she says. Black recommends frontloading. “If you have extra means or if [the child's] grandparents do, you can pump up the 529 plans,” she says. “Instead of just making an annual gift, you can dump in the first five years of annual [gift tax] exclusion.” For example, if a client can make annual gifts right now of $12,000, they can deposit the first five years–$60,000–into a 529 plan today without incurring any gift tax. The catch is that the client can’t make any subsequent gifts to that child within the five years. Also, if the client is married, both the client and his spouse can contribute $60,000–totaling $120,000–to the plan today. “That amount, growing at 8% for 18 years, can turn into a sizeable amount of money, instead of putting in $12,000 a year for 18 years,” explains Black. In fact, assuming an 8% return for 18 years, a 529 frontloaded in year one with $60,000 has an approximate future value of $239,700. If you were to invest the same $60,000 at $3,333 per year for 18 years, the fund would amount to only $124,800. The more you have upfront, the more bang you’ll get for your compounded buck.
Donas recommends putting more money into an older child’s account, since the client has more time to save for the younger child and the beneficiary of the original account can be changed to the younger child. He also believes in considering the in-state 529 plan first, as there may be tax benefits to clients if they invest in their state’s plan versus an out-of-state plan.
Roth IRA For parents who own a business, Black suggests the untraditional move of opening up Roth IRAs for the kids as a way to save for college. The money in the individual retirement account grows tax-free, and a large portion of it can be distributed without penalty to pay for qualified education expenses. Since IRAs are available only to workers who have “earned income,” parents would need to determine a business reason to hire their children and provide them with a paycheck. “Employ your child to do administrative work and with that earned income, you can open a Roth IRA,” advises Black. “This is a way for parents with a family-owned business to take a tax deduction for paying the child for the work, while also getting the benefit of putting money away in a Roth IRA for school.”
Insurance “The perfect plan has a 529 component and an insurance component,” suggests Donas, who says the life insurance component is important because a client may be putting about $1,000 away each month, and if something happens to that client, the child can still go to college, regardless of whether the parent is around for graduation. “You can always put money in an investment, but insurance should be the initial decision,” Donas insists. “If the parent doesn’t spend time on the 529 plan, we still know the account is taken care of and getting more conservative as the child ages [as the allocation within the plan changes], so it’s a great vehicle.”