Very few financial topics generate more questions to us than parents (and grandparents, too) asking how to set aside money for young people who presumably will some day go to college. Very few parents will be able to accumulate the $100,000 or more that it often takes to buy a four-year undergraduate education. But most parents can give their youngsters a start, and the earlier the better.

The College Board estimates that children born this year will face bills of $130,000 for four years of tuition at a public university in 2019. The cost may be $250,000 for a four-year education at a private college or university. Both figures are based on assumed inflation of 5 percent in college costs.

No matter how much time there is until your favorite young person must pay the bills for that first year of college, it’s not too late or too early to do something about it. Obviously, the earlier you start the more effective you can be.

So here’s a compilation of some of the advice we often give on this topic. We don’t have space to cover every aspect of the subject, but I hope the following answers to these two readers will help you point yourself in the right direction.

We told him that many people make the mistake of thinking stock market gains will pay for their children’s education, especially after the raging bull market of the 1990s. But over the longer term, the costs of higher education have been rising significantly faster than inflation. In some years the costs have risen faster than a prudent mix of investments can be expected to appreciate.

I recall some years ago when I was teaching a class in personal finance in the Boston area and one of my students, a physician with four children, asked me how much money he would have to save that year in order to pay for each of them to have eight years of higher education in the future.

I thought about the question, and the following week gave him an answer that didn’t make him happy. But looking back, it was probably a pretty accurate answer. I told him to calculate the current cost of one year of tuition and expenses at the schools he wanted his children to be able to attend. Then I told him to multiply that times eight, and again times four. I said if he put all that money away right then and invested it well, he would have enough.

In other words, his investment income after taxes would probably be enough to keep up with the rise in the cost of education – but not necessarily enough to pay the cost itself. In short, I was saying that if a full year of the education you want costs $8,000 now (this was 1976), set aside that full amount right now and the gains you can reasonably expect from a prudent plan of investments will probably keep that money up with the rising cost of college. This of course was an overwhelming task for him to do all at once – a total of $256,000 for four children.

If you try to pay for college from investment gains instead of your investments, you will almost certainly take much more risk than you ought to. And if you do that, there's a very real chance you won't have the money you need, money you could have if you were more conservative. In practical terms, this means don't invest in technology funds or individual stocks. It means don't chase the latest hot-performing mutual funds. It means don’t yield to the temptation to think you have found a way to outfox the market and take a shortcut to wealth.

With seven years between now and Freshman Class 101, you have enough time to invest in the equity market. That means one or more mutual funds that invest in U.S. and (if you have enough money to diversify) international stocks. You could do a lot worse than use the TIAA-CREF mutual funds, which we recommend often for college savings. They have a $250 initial investment minimum per fund, so you can get a lot of diversification even if you are starting small. They have several funds, but not such an overwhelming number that you'll be paralyzed trying to choose.

Start with the TIAA-CREF Growth Equity Fund or its close sibling, a “socially responsible” fund called Social Choice Equity if that appeals to you. This fund family also has an international equity fund that is widely diversified and has low expenses.

You may not want to hear this, either, but you should not keep your whole education fund invested in the equities market until the day you need it to pay for college costs. In the past, we have recommended a plan like this:

Two years before your son’s first year of college, estimate how much money you will need from your investments for that first year. Move that much into a short-term bond fund (TIAA-CREF has one of those, too, so you can do this easily). That way, you will take very little risk of losing that money in the markets. Six to nine months before you have to write that first check, move that money into a money-market fund so it is locked up airtight and can't be lost.

Take this same approach for the money you think you’ll need each year to pay for college. That way, you’ll gradually be moving money into less risky things as your time frame narrows. This approach doesn't guarantee you’ll get the highest returns. But it does guarantee that you will be reducing your risk as you get closer to needing the money. That’s the best any formula approach can do, and it’s far superior to speculating on the market's trend over a short period of time.

A couple of other options are worth checking out.

The first is called the 529 tuition program. This is an investment plan operated by a state designed to help families save for future college costs. It is named after a section of the federal tax code that provides benefits to participants. For information about these plans, visit www.savingforcollege.com. Near the bottom of that page, click on the FAQ link. Only you can determine if this is a route that you want to take.

The second alternative is the Ibond, an inflation-adjusted variety of U.S. savings bond. The interest they pay consists of two parts, a guaranteed rate that is fixed when the bond is issued and is good for up to 30 years, plus a variable rate that changes every six months and is identical to the percentage change in the Consumer Price Index for urban consumers.

The fixed rates on new bonds and the variable rates that apply to all bonds can change twice a year, on May 1 and November 1.

Ibonds on sale from now through April 30, 2001 have a guaranteed fixed rate of 3.4 percent. (It was 3.6 percent during the previous six months.) Until April 30, the variable rate on all Ibonds is stated as 1.52 percent, a six-month rate that would be equivalent to 3.06 percent if it continued for a year. Therefore the current Ibond rate is equivalent to 6.46 percent.

These bonds are targeted at long-term investors and are available in denominations from $50 to $10,000, and you can buy up to $30,000 of them per calendar year. Six months after they are issued, they can be cashed at any time; but there’s a penalty of three months’ interest if they are cashed within five years from the time they’re issued. Interest on the bonds is free of state and local income taxes, and federal income tax is deferred until they are cashed.

Ibonds have another feature that can make them quite attractive to parents and grandparents: There’s no tax on the interest if they are cashed to pay for qualified higher education expenses. If a parent or grandparent buys a $10,000 Ibond for a newborn child (assuming interest of 6.46 percent), the bond can be cashed for about $31,000 at the child’s 18th birthday – a great tax-free start on a college education.

These bonds could also be used for “parking” college money in the final years before the first tuition check is due. If you convert equity investments to Ibonds five years before you expect to need the money, you can avoid the three-months interest penalty. While the interest on Ibonds is unlikely to equal or exceed the rate of rise in the cost of higher education, that interest is tax-free if used for that purpose. And that’s certainly a help.

For more information on Ibonds, visit www.publicdebt.treas.gov/sav/sav.htm.

Nobody can predict with any certainty what college costs will be in the future. But it’s not hard to make a few ballpark estimates and figure out how much you’ll have to save.

On the Web, use the College Savings Calculator at www.tiaa-cref.org/tuition to see how far your present savings will go toward a future tuition bill – or to find out how much you’ll have to save every month to send a young person to college. If you know the current tuition at a particular college, you can enter that information plus an assumed rate of inflation to find the estimated future cost.

Second reader’s question: A woman wrote to say she wanted to set up a Roth IRA with $2,000 for her 3-year-old granddaughter’s college fund in order to save taxes.

We told her that was probably a bum idea. Unless this 3-year-old was a very unusual case, she would not have the $2,000 of legitimate earned income necessary to qualify for making a Roth IRA contribution.

Starting a Roth IRA later may not provide much advantage, either. Unless the Roth IRA has been established for at least five years, withdrawals of earnings are taxable in the year they are withdrawn. (Withdrawals of principal are tax-free in a Roth IRA.) In practical terms, because of the way the law defines the five-year period, a child should open an IRA by the age of 12, with a contribution based on legitimate earned income, to be sure that earnings can be withdrawn tax-free in the first year of college.

Even when that hurdle is overcome, the annual limit on IRA contributions effectively limits the amount of earnings that can build up tax-free in five years. There is some benefit, but not a great benefit.

However, if the grandmother has earned income, she could open her own Roth IRA and designate the granddaughter as beneficiary. That way, all the earnings could be withdrawn tax-free any time after five years to pay the granddaughter's education costs.

But, in addition to the suggestion to check out a 529 tuition program, we offered the following alternative. If the grandmother can afford to pay the taxes on a mutual fund account (we also suggested the TIAA-CREF funds to her) as it builds up, the grandmother can keep complete control of the account by registering it with her and her granddaughter as joint owners with right of survivorship. That way, if anything happens to the grandmother, the money automatically goes to the granddaughter. And otherwise, the granddaughter can’t get her hands on the money until the grandmother decides the time is right.

This arrangement has one other advantage over an outright gift, assuming the mutual fund is registered with the grandmother’s social security number. Under standard guidelines for financial aid, students are expected to use up their own savings and investments for paying for their education, and their parents are expected to contribute a percentage of their own assets; financial aid is reduced accordingly. But this “expected family contribution” doesn’t extend to grandparents, and money belonging to a grandparent may be invisible on the radar screens of financial aid officers.

Finally, we wrote: “You sound like a generous grandmother, and you can do something even more important in addition to this investment. Make sure your granddaughter gets lots of educational experiences and opportunities between now and the time she’s ready for college. Travel, museums, books, theater … there are all kinds of things that will have a big impact on her life. And as her grandmother, you are in a perfect position to expose her to some of the more interesting things that life has to offer. This will be good for her. And it will be good for you, too."

 

 

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