I am on a crusade to optimize my family’s finances. For years, I wasn’t very attentive to my finances, or how my few investments were performing. I took advice from co-workers and bought what other people mentioned to me. I put some money into TSP each month, but didn’t think too hard about what funds I had. And later, as we had kids, we started investing in USAA’s 529 college funds, because I had an account with them.
Recently, I started reevaluating our children’s college savings. What I found shocked me. The fees charged by my 529 college funds were much higher than I realized… an average 0.93% for our kids’ age-based funds, with a maximum of a 1.06% of the total balance every year (for a child ages 0-2). Subtracting a 1% annual fee from a hypothetical 5% return can have massive affects – reducing returns on a $10,000 investment by 33.2% over 30 years! For more info, check out my previous post entitled, “Aggressively Attack Fees to Keep More of Your Profits”.
Though (like many of you) I’ve transferred my GI Bill to my kids, those 36 months of benefits don’t pay for college for three kids. One of our financial goals is to save enough for our kids’ college educations, in addition to funding our own retirement needs. Because of this, creating a good plan to save for our children’s educations is a priority.
However, before I show my family’s new college savings plan, let’s cover the basics:
Types of College Savings Plans:
There are several types of widely-used college savings plans, many of which are tax-advantaged (i.e. you’ll pay less taxes and keep more of what you save, which is always good). Here are the main types of accounts that meets this criteria:
- Coverdell Education Savings Account (ESA)
- 529 Plan
- Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) Custodial Accounts
For this post, I’ll primarily focus on ESAs and 529 plans. There are also some that recommend saving for college in other ways, like using a standard brokerage investment account (not tax-advantaged) or in the parents’ Roth IRA. I would recommend using one of the tax-advantaged options above as your primary option, especially not sacrificing your Roth IRA savings.
Though we love our kids, saving for their education at the cost of your own retirement Roth IRA is generally not a good idea. If you want to ensure that you don’t become completely dependent on the government to pay your bills (via social security and/or your military pension), or don’t want to become a financial burden to your children, make sure you invest in your own future as well. You can’t eat your child’s college education, and I hear that cat food doesn’t taste great.
Finally, do not keep your college savings in a bank account (at least, at first). Though this gives you the most flexibility and doesn’t risk money in the market, it is also guaranteed to lose a lot of spending power. With the cost of college rising 8% each year, you are putting your money in a leaky bucket if your college savings are in a traditional savings account. Starting at birth, you would have to save about 60% more money in a savings account vs. in an ESA or 529 plan with just a 5% annual return.
Coverdell Education Saving Account (ESA):
An Education Saving Account (ESA) is a special, tax-advantaged investment account that lets you save up to $2,000 per child per year for qualified education expenses. Here are some of the pros & cons:
ESA Pros:
- Tax-Advantaged: Uses after-tax dollars, but earnings grow tax-free and no federal income taxes
- Very Low Cost: Some low-cost investment companies (like Schwab) provide ESAs without any additional fees/charges.
- Lots of Investment Options: ESAs allow you to invest in whatever you want – to include stocks, bonds, and index funds. At least in Schwab, it acts like a Roth IRA or any other investment account
- Lower impact on financial aid: Counts as a parental asset, and has less impact on need-based financial aid
ESA Cons:
- Only $2,000/year: The biggest drawback is that you can only contribute $2,000 per year per child. Because this only allows you to contribute a maximum of $36,000 over their lifetime, you will need an additional college savings account (like a 529 plan) to cover the rest.
- If You Make A Lot of Money, You Can’t Contribute: There are income limits for ESAs. You can’t contribute if your adjusted income (MAGI) is over $110,000/year for single filers, or $220,000/year for married filing jointly
- Use for Education, or Pay a 10% Penalty & Taxes: As long as you use it for qualified education costs, you should be fine. But, if you decide to withdraw your money for other reasons, you’ll pay a 10% penalty and taxes.
- At Age 18, You Can’t Contribute Anymore: When your child is 18, you can’t contribute any more to an ESA
- By Age 30, You’ll have to Transfer or Spend: By the time your kid reaches Age 30, you’ll have to either transfer the remaining funds to another family member, spend or withdraw the money.
In general, an ESA is great for do-it-yourself investors who want more investing control and potentially lower fees. However, you must meet the income limits and can only invest $2,000/year for each child… meaning that you’ll likely need an additional college savings account (like a 529) if you want to cover more of your child’s college costs.
ESAs are offered by many different investment firms, to include Schwab. The primary concern should be minimizing fees, especially because so many companies provide accounts at no cost.
529 Plans:
529s are also tax-advantaged savings accounts, but they are different from ESAs in several ways. Unlike ESAs, 529s are state-sponsored education savings plans that usually have limited investment options (though, some have more options than others). However, 529 plans do not suffer from the same low contribution or income limits as ESAs, and can even have major state income tax benefits for state residents.
Here are a few pros and cons of 529 plans:
529 Pros:
- Tax-Advantaged: Though it uses after-tax money (i.e. you don’t get a tax write-off), but the earnings grow tax-free and you don’t pay federal income tax on withdrawals for education expenses
- No Income Restrictions: Unlike ESAs, there are no income limits
- No Annual Contribution Limit: No annual limits (though, be aware that gift tax may apply if $15,000 or more is contributed per year)
- No Age Restrictions*: No age restrictions for contributions (in most states)
- Lower impact on financial aid: Counts as a parental asset, and has less impact on need-based financial aid
- Transferrability: Money invested in a 529 can be transferred to another family member
529 Cons:
- Can have higher fees than ESAs: Some 529s can provide only actively-managed investments, which can lead to higher fees (i.e. around 0.6-1.0%). You’ll have to dig into their fee schedules to see what you’ll be charged.
- Some have limited investment options: This isn’t always the case, but some 529s give no options at all (and automatically invest based on your child’s age). Some people prefer this, but if you want to pick your own investments, you’ll need to do some research
- Use for Education, or Pay a 10% Penalty & Taxes: As long as you use it for qualified education costs, you should be fine. But, if you decide to withdraw your money for other reasons, you’ll pay a 10% penalty and taxes.
To research more about 529 Plans, I’d recommend starting with Morningstar’s annual ratings and other 529 articles. Programs such as Utah’s my529 and Illinois’ Bright Start Direct-Sold College Savings are perennial gold rated programs.
Uniform Gifts to Minors Act (UGMA) & Uniform Transfers to Minors Act (UTMA) Custodial Accounts:
Though most college savers will find ESAs and 529 plans to be most beneficial, UGMAs and UTMAs are also a viable option. However, they are very different from both of those options. UGMAs and UTMAs are custodial accounts, where gifts can be transferred to minors. Once the account matures (at age 18 for UGMAs, or age 21 for UTMAs), the assets are transferred to the child to spend as they will.
The primary benefit of these accounts is that the assets do not necessarily have to be spent on college expenses. However, for financial aid they are counted as the child’s assets, which means that 20% of these assets will count against them for needs-based financial aid.
If your intent is to save for education, then a UGMA or UTMA is not the most efficient investment. However, if your plan is to transfer savings to a child (to do with however they see fit) for when they come of age, they can be an effective tool.
For UGMAs and UTMAs, you’ll need to do more research to see if they work for your family’s situation. This website provides some overall information about these types of custodial funds, as does this post from Merrill.
So, what does all of this mean for me?
After all of this information, my recommendation is to start by deciding on what college savings method(s) you want to use based on your own situation.
For those who like simplicity:
For those who don’t want to manage multiple accounts, opening a 529 plan is probably the best bet. That way, you only have a single account for each child (vs. having an ESA and a 529 for each). You may pay slightly more fees, but if you pick a 529 with low-cost investment options, you can save yourself the extra work and still invest in your children’s education.
Some great options are Illinois’ Bright Start Direct-Sold College Savings and Utah’s my529 plans. A great place to start your research is this Morningstar report from 2020.
For the DIY Investor:
If you want to have more control over your children’s college investments and your income is below $110,000 (for single filers) or $220,000 (for married filing jointly), you could instead start with an ESA. These have the lowest fees… and lower fees increase your return. Because you cannot contribute enough to an ESA to pay for any child’s college costs, then would also need to open a 529 for each child. Max out your ESA contributions first ($2,000/year, or $166.66/month), and then contribute any additional college savings into a 529 Plan
The exception is if your 529 Plan gives a state income tax deduction (like Illinois’ Bright Start 529) and you are a resident of that state. In that case, you would want to prioritize the 529 first (or avoid an ESA all together). Like with most investing, deciding on what you invest in depends on your personal situation and what works best for your finances.
My Personal Plan (for My Family):
In researching this post, I reevaluated our family’s own college savings. At the start, I had three USAA 529 plans (one for each kid). These 529s charged my family an average of 0.93% per year in fees and had no flexibility in how my money was being invested. Because I enjoy investing and hate high fees, I needed a change.
Everyone’s college savings plans will be different, based on their income, number of kids, and personal preferences. However, here is the plan I settled on based on our situation:
- Opened three ESAs with Schwab (one for each kid) and set up automatic transfers each month. I couldn’t afford to max them out ($2,000/year per kid, or $166.66/month) because I have three kids and that’s a lot of money for me (without lowering my retirement investments)
- To eliminate the fees from my USAA 529 plans, I performed a 529 Rollover to Illinois’ Bright Start 529 plan. Essentially, I moved the money invested in my existing 529 to my new Bright Start 529 plans, which you can do only once every 12 months. Bright Start is highly rated, has a great selection of age- and index-based investments, and gives a major state tax write offs in Illinois.
– Before performing a 529 Rollover, make sure you understand the tax implications. - The plan is (for now) to put nearly all new savings into the ESAs. Once I’m able to save enough max out the ESAs, any extra college savings will go to the Bright Start 529s.
– After I retire (and if I become an Illinois resident), I will instead put most of the money into the Bright Start 529s to capture that large state income tax write-off ($20,000 for married filing jointly)
In the ESAs, because I’m investing small amounts of money each month (and not enough to buy most of the ETFs I prefer, like VTI), I’m only purchasing low-cost Schwab index mutual funds in these accounts. This is primarily because there are no fees for buying Schwab mutual funds on Schwab, and I can buy small amounts each month. I am picking a fairly aggressive mix of funds based on the ages of each kid, with the majority of money invested in a total market index fund (SWTSX).
In the Bright Start 529, I am investing in the “Index-based Investment” Vanguard Funds (listed on their website). I didn’t invest in the “Multi-Firm Investment” funds because their fees are much higher due to their mix of actively-managed funds.
Conclusion:
Saving for college is a major concern for many military investors, especially those with multiple children. Start by building a plan, and then set up your own automatic transfers. Decide on your investments, and continue investing on a regular basis.
If you are able to help curb the pain of college debt for your kids – without sacrificing your own retirement in the process – you can give them an amazing gift: a better start in life.