You can use different accounts to achieve different goals when saving for you children's college education. Take advantage of the best features of Roth IRAs, 520 college savings plans offered by states and 401(k) plans to meet both retirement and college education targets.
In saving for your children's college education, you have many choices in types of accounts available and reasons why you might choose one type of account over another. But directing savings to different accounts, if possible, is a good strategy so that you can take advantage of investment possibilities.
College Costs and Roth IRAs/401(k)s
Roth IRAs offer you the most flexibility for college investments. Most people should fund their retirement before saving for their children’s college needs. It’s entirely possible that your child won’t attend college, drop out before graduation, choose vocational training, or travel around the world instead. You may have sacrificed to save and then get socked with a penalty to recoup that money.
So, if you’re eligible based on income (below $122,000 single; $193,000 married filing jointly), contribute the full amount to your Roth first ($6,000 per person; an additional $1,000 if you’re over 50). That’s $12,000 a year if both parents have accounts: a significant start on a college war chest. If your child doesn’t need it, great! Use it for retirement.
A Roth can be considered a very long-term investment. If you can tolerate the higher risk, this is a good place to emphasize well-considered individual stock purchases using all the principles of BetterInvesting: good quality, good expectation of price appreciation, good value, and diversified for size and industry. You can trade in this account with no tax consequences, and as long as you only withdraw the amount of your contributions for education, you won’t pay taxes on withdrawals. There’s no obligation to clean it out or expend the entire account on the student.
If your investment strategy includes bonds or bond mutual funds, they can also be held in this account, as can alternative investments such as REITs. Since this account will be held for a long time and may not be needed for college, you can chart your own strategy.
Employer plans such as 401(k)s might be a possibility for backup college funding if the plan will allow you to borrow against it for tuition. Generally, I don’t recommend this unless the account has a truly huge balance. Isolate this for your own retirement.
The Core Education Savings Plan: the 529
529 plans are the bedrock of savings specifically designated for college. Once you have your Roth funded (if you’re eligible) and are contributing to your employer plan at least enough to get any match, you can move on to saving in a 529 plan. Although this is a core strategy, like most core portfolios your options will be safe but probably unexciting.
For example, in Illinois’s plan, you can choose from age-based index fund portfolios (mostly Vanguard index funds) or a multifirm strategy with a premixed selection of T. Rowe Price, DFA, Dodge & Cox, etc. — a more active management style. Or you can choose target portfolios based on how aggressive or conservative you want to be; these remain the same over time. Finally, you can choose your own mix from 15 different portfolios, including several bond and stock fund options, real estate funds, and international .
Does this sound like your 401(k)? That’s because the plans want you to make good choices, and if you can’t or don’t know how, the choices can be made for you. 529 plans are not in business to encourage adventure or speculation and have been heavily criticized in the past for losing money in economic crises where parents have found they have far less money available than projected.
Even with such prudent, vanilla choices there's no guarantee you’ll have the returns or portfolio value you anticipated, unless you keep it all in cash. But if you do, you’d better plan on saving a lot to cover the inflation in college costs. It’s hard to look at your infant and imagine what cost of attendance might be in 18 years.
Employ Aggressive Investment Strategies
Don’t bet the farm (or the entire college account) on high-risk or aggressive investments unless you’re sure you can tap other sources to meet your college goals. Let’s say you’re a high-earner and could pay a significant amount out of pocket. Then you can choose to allocate the Roth or a taxable brokerage account to aggressive investments in the hope you won’t have to pull money out of your pocket and the account will grow to fund college costs. Or perhaps a spouse can return to work or get a better job during the college years if necessary. With these possibilities, you can stomach the risk.
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Balancing Risk and Reward When Saving for College
Another factor in whether some of your college goals can be funded by high-risk investments is how long you have before the money is needed. If you have an 18-year runway, you have time to recoup temporary losses. But if the losses are early on, they may set you back from maximizing the magic of compounding.
You can choose to keep your core 529 funds in a moderate-risk portfolio but reserve a smaller account (Coverdell education savings account if eligible or a brokerage account) for investing in the hope of maximizing return.
There is one situation where this is a terrible idea, however: If you know that you have really inadequate savings, this is not the time to go to the roulette table in hopes of a lucky strike that will provide the magic answer. Stock investments should be done thoughtfully, with realistic expectations and realization of risks. It’s better to have less money solidly in place then to take the chance of losing it all, especially just before the money is needed.
Danielle Schultz, CFP, is a fee-only financial planner and principal of Haven Financial Solutions in Evanston, Illinois.