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College Savings Simplified: The Best Places to Save Money For Education

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While I tend to do things the hard way, finding college savings isn’t one of the areas where I complicate a task. For some reason, my sixteen year old twins helps me focus on whether a 529 plan, Roth IRA, or savings bonds will treat me right.

So, even though I’ll generally remember to add softener to the washing machine just after it’s finished, I understand how college plans operate up and down.

If you’re saving for college, it’s important to categorically work through the details of each plan to determine which best fits your needs.

…because there IS A right way to save for college, and a wrong way to save.

The bad news? The BEST way to plan college savings differs depending on who you are and what your circumstances may be.

I know that sounds generic and evasive, but it’s true: the best way to save for college will depend on your own income, current savings and college goal, so the best course of action will be this:

Know what plans exist and how they’ll affect your ability for financial aid before investing a dime.

If you haven’t yet, you should read the pieces on:

– 5 Steps to a Successful College Plan – This will guide your plan of attack when creating a college plan.

– Narrow Your College Search – This will focus your college search to those schools which are the best fit, both financially and for your particular interests.

After reading these two thorough primers, you’ll be armed with an idea of the cost and feasibility of your favorite school.

 

Let’s now save for the goal: education.

 

Complicated Ways to Save For College

 

Some methods of saving for college are so fraught with risk that I’m reticent to ever recommend them to people. That doesn’t mean that these college savings plans are bad; on the contrary, they all have some huge upside potential, provided that all the right conditions exist. Here are a few:

 

In-State Tuition Reimbursement Plans – Many states offer plans which reimburse the cost of college credits at a later date. This can be a fantastic way to lock in the price of a college, provided that everything goes according to plan.

Upside: Paying today’s rates for in-state public institutions. Don’t have to worry about market conditions or returns on investment.

Downside: Have to worry about state plan solvency. More than one state has already notified participants that they might not be able to meet their obligation. In fact, some plans no longer guarantee that your dollars will lock in present rates. Instead, these plans invest your money with state funds. Who wants their state government as a money manager?

 

 

Life Insurance – Some life insurance plans, such as whole life and universal life are presented as attractive options for education savings vehicles.

Upside: These plans are financial-aid friendly. When completing a FAFSA application, money inside of life insurance policies doesn’t count against your savings, acting as a nice shelter. Also, if for some reason the insured passes away, money is available for education.

Downside: You may have to cancel your life insurance policy to withdraw education funds. What if you still need the policy? Also, do you really need life insurance? If the answer is yes, and you’re sure that you will no longer need coverage after this incident, then this might be a good option.

Watch out for fees, too. Not only will you pay for insurance, but often a policy which offers stocks and bonds are filled to the brim with fees to manager and (maybe more importantly) to withdraw funds.

Still want life insurance in your account? Read this good article at FinAid.org for a more in-depth argument: Variable Life Insurance Policies.

 

Annuities – Tax deferred savings may seem like a good option for education planning. Why save into an account that’ll be taxed every year when you can shelter your money?

Upside: These accounts are FAFSA friendly, meaning that they are not usually counted in the equation for financial aid. Many annuities offer some flexible savings options.

Downside: Too many to mention here, but mostly: fees and penalties. Make sure you’re going to be over age 59 1/2 before you remove money, because if not, there’ll be IRA penalties on top of whatever the annuity company may charge.

Taxes can be a bear. Here’s why: when you withdraw cash, dollars in the account are removed in a LIFO (last in-first out) accounting manner. This means that all interest on the account must be taken before principal is removed. Why is this a big deal? Taxes. You’ll pay taxes as if you earned the money in the year you remove the money. This income may also make your chances of receiving financial aid worse in the following year.

 

Less Complicated But FAFSA or Tax Return Unfriendly

 

Stocks or Stock Based Mutual Funds – These accounts can be used whenever you wish, assuming the dollars aren’t inside of a tax shelter. In some years there’s a chance of nice returns, too.

Upside: Returns. While there are no guarantees, over long periods of time the instability of a stock or stock-based exchange-traded fund or mutual fund can be countered with a high average annual return.

Downside: Risk. There is a chance you could lose a substantial amount of principal if you don’t monitor or manage your money. Also, this type of investing isn’t FAFSA-friendly. Dollars that aren’t sheltered count directly against your chances of financial aid.

 

 

 

Bonds or Bond-Based Mutual Funds – More stable than stocks, these types of funds have performed attractively over the last ten years.

Upside: Returns with generally less risk than stocks above. Because bonds throw off dividends as one of the main methods of creating returns, these investments often perform more consistently than stocks.

Downside: Taxes. Bonds often throw off an attractive dividend that savers often reinvest. This money, unless it comes from a special type of bond such as a municipal bond fund, is taxable every year, slowing down your return. While there has been tax reduction with capital gains taxes, these are taxed as income, which is a much higher tax bite. These are also FAFSA unfriendly investments, unless you use government savings bonds. These can be good to you tax-wise, as long as they’re titled correctly and cashed in the same year as you’re paying qualified education expenses.

 

The Easy Way To Save For College

 

Roth IRA Plans – A Roth IRA is generally a retirement savings vehicle. Money invested gives you no tax benefit today, but can be taken tax free during your retirement years. You’ll have to follow a few rules, but you are allowed to withdraw funds for college. You may also use nearly any time of investment you choose inside of a Roth IRA.

Upside: Tax shelter. This money can grow tax deferred for education, and if you end up not using it can be used later for retirement, tax free.

Downside: Retirement savings. The best use of a Roth IRA is clearly as a retirement savings vehicle. While money can be used for college, why miss out on the main Roth opportunities around retirement?

 

Coverdell Education Savings Accounts (ESAs) – These plans allow you to save not only for college, but also for earlier years of private school expenses.

Upside: Flexibility. This tax shelter allows you to use money for many types of education options, so it’s great if you’ll have elementary, high school and college savings needs.Classroom

Downside: Funding. Man, these accounts are small. Because you can only place $2,000 per year into this type of account, they often don’t make sense. I’d also meet people with very limited funds in a few different Coverdell IRAs. Who can manage all these little accounts effectively?

The IRS page on Coverdell ESAs is very helpful. Find more details here.

 

529 Plans – State sponsored education plans offer a good tax shelter, are somewhat FAFSA friendly, and eliminate taxation of dollars as long as funds are used for qualified education expenses.

Upside: Amounts of savings. You can pack tons of money into these plans. Most allow as much as $300,000 to be invested into a 529 account. These accounts can either be in self-directed fund options or can be in age-based options. If you don’t use the money for the primary beneficiary, funds may be used by siblings, parents, children or other close relatives. In these plans your choice of education institutions isn’t limited to a single state. You may use these dollars in any state and still receive the tax benefit.

Downside: Money earned in a 529 plan must be used for education expenses or you’re slammed with penalties. If you aren’t sure about saving for college, funding your Roth IRA first might be a better idea, because while these funds are flexible for college funds, money will be trapped here.

 

Of these, the savings option I like best is a 529 plan, because of its flexibility, range of schools that accept funds, and tax treatment. While it isn’t best for everyone, for the vast majority it’s where you should save for college.

 

Here’s How To Evaluation 529 Plans

 

Just like we’ve told you previously that Morningstar is the best way to evaluate mutual funds, I like savingforcollege.com to evaluate 529 plan options.

Here’s a link to savingforcollege.com. Have a look around to see how thorough this site is on investing for education.

The Good – Lots of information on FAFSA and college savings options. Great reviews on the fees associated with 529 plan savings accounts.

The Bad – While fees are certainly important, I’m about returns. Savingforcollege.com does a poor job of comparing how money managers work unless you’re willing to fork over some money for a premium membership. When compared to more robust money management sites such as Morningstar.com, there’s no reason to pay for this information.

 

Can I recommend a single-best 529 plan?

 

Absolutely not.

Check your state’s plan options at savingforcollege.com to see how they stack up. Always evaluate a few national plans to see how they compare against your own state’s options.

My favorite national plan is UPromise, though I also like the T. Rowe Price option.

Why Upromise?

I’ll attack this next week, but here’s a preview: not only is the plan managed better than most options available, but if you sign up your credit and debit cards, but using the Upromise Rewards program (which you can sign up for whether you use a Upromise 529 plan or not) you’ll receive points which can translate into extra money into the 529 plan later. Combine the benefits of low cost investing, good management and extra money, and you’ve found a plan that’s hard to beat.

If you want to compare Upromise with your state’s plans, here’s a link for more information: Upromise is the smart way to save for college!

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Life Insurance: What’s the Right Type of Life Insurance?

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I’m not a big television watcher, so I’m sorry to say that I don’t see much Dancing with the Stars. I know, you had such high hopes for me. My wife watches the show, so sometimes when I’m playing around on “the Twitter” I’ll sit with her on the sofa. On more than one occasion, I’ve half-witnessed a total breakdown by the “star” because the workouts were too hard. What’s interesting is that these “stars” end up achieving nothing on the show while the harder working pairs continue on. Even if they don’t win, those stars that worked hard talk about how rewarding it was to learn something new.

That’s what we’re going to do today: throw out rules of thumb and learn how insurance works. I am totally an analogy ninja.

He did so well last time, The Other Guy is back to write another scintillating post on insurance. If you missed his last one, you may want to start here: Find the Right Amount of Life Insurance in 10 Minutes.

Everyone wants to use rules of thumb, or “what I heard from my friend” to decide which insurance is best. Why throw a dart when it’s nearly as easy and far more profitable to just do the homework?

I hear experts tell us to always buy term insurance. Or they moan that universal life coverage is a rip-off. I agree that there is one type of insurance that’s best for everyone, but:

The best type depends on what you’re going to use the coverage for and how long you’ll need it.

Decisions …so before you believe someone telling you that one type of insurance is better than another, minions, know the available types and how they work! Last week I shared a quick formula to determine how much coverage you’ll need. Let’s use another quick method to understand your choices when it comes to life insurance.

Just as a carpenter needs to know the difference between a hammer and a drill, you’ll need to know all the types of insurance to pick the best kind. Don’t worry, I’ll keep it entertaining.

Term Insurance is probably that most well known type of coverage. Because it’s stripped down coverage, it’s often the only type available in workplace plans. Term insurance is nearly as easy to understand as first grade math: you pay for a specific amount of insurance which covers a set amout of time, called a ‘term’.

Helpful example: Barry Manilow purchases a $250,000 10-year term policy. If he dies during the term, Mandy, his beneficiary would receive $250,000 tax free simoleons. If Barry expires one minute after the term ends, the insurance company owes Mandy nothing.

Whole Life Insurance is equally well known. These plans began decades ago as an alternative to term coverage mainly because the coverage lasts…wait for it…your whole life. Awesome, huh? I know. Marketing and naming wizards, those insurance companies. Most whole life policies contain a “cash value” component that can be cashed in by the owner. Whole life policies require payment for their…drum roll please…whole life, unless you buy a policy that can be “paid up” early. Generally speaking, whole life = coverage for your whole life and premiums for your whole life.

What’s awesome about whole life insurance? Guarantees! If you continue to pay the premium to the insurance company and keep your account in good standing, it’s guaranteed to last. The cash value grows at a guaranteed rate, so you don’t need to worry about interest rate fluctuation much. It’s a wonderful policy type for the super-nervous people of the world.

Universal Life Insurance is a variation on whole life – at some point insurance people said, “Wouldn’t it be cool if the payments to the policy and death benefit could be partially flexible?” Maybe they didn’t ask that exact question, but it makes the point. People who own this insurance pay extra (just like with whole life coverage) to add money to a cash value portion of the policy.

Once enough cash value accumulates, you can sit back and let the cash cover the costs instead of paying more money from your wallet. Many policies allow you to raise or lower the amount of coverage without having to purchase another one.

What’s another key difference between universal life and whole life insurance? Okay, I’ll tell you: universal policy interest rates on cash often float with interest rates. Awesome during 1980 when CDs were paying over 10 percent. Now, though, with the value of savings through the floor, universal policy rates are Coyote Ugly. And no, that’s not code for awesome, like the model-bar.

Variable Universal Life is the newest of the 4 major types. Those crazy insurance companies were getting smoked because the average saver decided to invest money into the financial markets. Marketing people said, pulling their hair out, “what will we do to keep business coming in?” Once again, the phrasing is off, but VUL policies (as they’re known in insurance lingo) were a reaction to the widespread use of mutual funds and other investment tools.

Initially developed in the late 70’s and early 80’s, these types of contracts allow for investment in various stock/bond accounts (similar to mutual funds, but not the same). The major draw of VUL? Flexibility of investments became the name of the game – and the opportunity to have market-like returns right inside your very own life insurance policy. In the go-go 1990’s, this was awesome. Since then, many investors have had middling returns and unpredictable results.

Which is best for the salesman?

In the interest of fair disclosure, I’m going to let you in on a little secret. Life insurance is a BIG commission check…I mean GIGANTIC. You wouldn’t believe how much. Let me give you an example: If you’re a 40-year old man buying a term policy that costs $100/mo; your insurance sales person gets around $850-$900 cash for the first year of your premium payments. Yes, you read that right, you basically pay a year’s worth of premiums to cover the commission amount. I don’t mean to infer that this is bad…it’s just how things operate.

Just thought you’d like to know.

Whole Life, Universal Life, and Variable Universal Life are even bigger payers. I remember receiving a check for over $25,000 for a single $400,000 Variable policy I sold early in my career. I also remember a $70,000 commission check for a $2 million policy. Big money.

My goal isn’t to make you angry. It’s to help you know the broker’s game.

…which brings brings us to the “One Question You Should Ask Before You Buy Anything”:

“Mr. Broker, how much money are you going to make if I buy this insurance?”

I was never ashamed to admit to my clients how much money I’d earn…a good advisor has no reason to be deceptive. But, if he hems and haws…maybe this “complex insurance investment strategy” that sounded pretty cool benefits him more than you. In my opinion, the actual commission is irrelevant – it could be $2 or $20,000, I don’t care – it’s how he answers the question.

All Insurance Types Cost The Same

Sometimes insurance agents will mention that permanent policies, such as universal or whole life, are less expensive than term insurance. I’ll lay it out and let you decide:

Sure, like some margarines are saltier than others, some carriers offer better premiums for smokers, race-car drivers, or 45-year olds. That’s true. However, insurance ‘costs’ among competitors are far closer than you’d initially imagine.

In the above example you’ll see the differences between permanent and term. Notice additional fees (in the right chart, 5 percent is deducted as an additional charge—this fee can be higher or lower depending on the carrier).

Here’s how all insurance costs are similar:

Insurance is sold in $1,000 increments. Imagine pulling up to the insurance store drive thru and ordering 500 $1,000 units of insurance. The cashier calculates the cost based on two factors: your age and the number of $1,000 units you’re purchasing. I hate to disclose this secret: actuarially you’re more likely to die every year you age.

With permanent life insurance, your “cash value” grows over time, reducing the amount of life insurance you buy from the insurance company – which makes it seem like you’re paying less for coverage.

A second handy example: if Jeff Gordon races to buy $500,000 of coverage and he stuffs $50,000 of cash into the policy – his beneficiary would receive $450,000 of insurance and $50,000 OF JEFF’S OWN MONEY to total $500,000.

Permanent life insurance is only cheaper because you’re paying extra into cash when you’re young, which lowers the amount you’re buying later on when it’s expensive.

Whole life, UL and VUL insurances in many ways are forced savings accounts added to life insurance.

Which Should You Buy?

So…which one is best? Well, that’s a loaded question – but here’s what I think. Start by determining how long you’ll need coverage. For the vast majority of savers, maxing out a Roth IRA and 401(k) plan and buying term insurance is the right answer. If you have a long term need and have a maxed out Roth IRA, 401(k) and you still have money left over…well then maybe a permanent policy may be a better choice.

For this reason, using term insurance for succession planning needs at work or estate liquidity needs to cover estate taxes usually ends in disaster. These policies need to be in-force when you die, so permanent insurance works best.

If you’re a worrier about outliving your insurance and want forced savings, whole life, UL and VUL aren’t the enemy. I’ve had clients purchase permanent insurance only because they wanted security and were comfortable paying a lot of money for it. These policies work, but for a cost.

Because most families need life insurance for a fixed amount of time and have other ways to save money, term is often the best choice.

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Find the Right Life Insurance Amount in 10 Minutes

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Another note from AverageJoe’s Thanksgiving visit to the in-laws:

Dear blog diary,

I’ve just trounced my mother-in-law at Scrabble again. It was absolute luck that the triple word score was open for my play of “austerity.” Of course, I had to hide a U and Y in my sleeve to place a nine-letter score. Luckily, we’ve both had enough “holiday cheer” that she didn’t notice. I know that to be a good son-in-law I should let her win, but not until I get a chance to play the word “bailout.”

Between all this winning and making Rice Krispies Turkey Pop Treats, I totally can’t be bothered to post anything today. Instead, I’ve opened the basement and let out The Other Guy, so named because he’s still a practicing financial advisor and doesn’t understand that being associated with me would totally be good for business. Whatever.

We’ll have a special piece tomorrow, but will completely understand if you don’t have time to read it. Safe travels, everyone!

Now, on to the Other Guy:

 

 

A couple of weeks ago, after being sick for about 10 days, I finally went to the doctor. Apparently, I have ‘walking pneumonia.’ I told the doctor that I don’t do any physical exercise, including walking, so I couldn’t possibly have “walking” anything.

In any event, I didn’t feel well. I began to contemplate my own mortality and then an idea popped in my mind: let’s spend a couple of days talking about life insurance! It’s obviously everyone’s favorite topic…and as a financial advisor who doesn’t like to be sold some insurance, I make the perfect teacher. As AverageJoe did with the “evaluate a mutual fund in 10 minutes” post, I’m going to break it down nice and easy for ya’.

Here goes:

Before anything, let’s not waste time evaluating coverages if we don’t have to. All too often, insurance sales professionals and financial advisors will just make the assumption that you need it and proceed to sell it to you. Here’s an easy way to determine if you need life insurance at all:

Questions to ask:

Does anyone rely on you for financial support, either right this moment or if you got hit by lightning?

If you’re single and/or have no dependents, there’s almost a zero point zero percent chance that you need life insurance. I might be convinced that a small group policy so that someone can bury you is adequate. If you have charitable intentions, there are insurance strategies that work really well….but that’s all. Nothing more.

Don’t let an insurance salesman tell you otherwise.

For those of you who have people relying on you for financial support here’s an easy way to calculate how much you need. Is this the best way? Nope. However, once we walk through these steps you’ll be on your way to making a good insurance decision.

Every life insurance discussion contains assumptions. You’ll need to make some to decide what amount is right for you. At the least, you’ll need to know where assumptions have been made, so you’re able to change directions if you need to.

Here are a few assumptions:

If married, I usually assume with clients that they’ll want the mortgage paid off when they die. Even if both spouses have a full time job and can still afford the house, I’ve seen too many people “go off the deep end” when their spouse dies to determine whether everything will remain stable at work and home. I can understand leaving this out, but at the least I’d evaluate your insurance cost with and without this cost before deciding to drop it.

You may find the additional cost is worth the pain.

If you have children, I assume you’ll want them to go to college, and you’ll want it paid for . Maybe not Harvard or Yale, but you want them to have some level of in-state public university education. Since college costs increase 8-10 percent per year on average, this is one of the most expensive budget items a family can face.

Let’s have the discussion here that we’ll have in client meetings: Maybe you paid for your own college expenses. Evaluate your children and savings and not your personal situation when you went to school. With costs rising quickly, do you want them to have this burden?

Here’s how much life insurance you’ll need…plus or minus the assumptions above plus a few more below.

Add together all of your debts, including your mortgage: $__________________

I’ve done the math on an average in-state tuition in the chart below. Add in these costs: $__________________

Next, we’re going to give your family basic income to live on. Here are where we need to make some large assumptions. Take your annual post tax (take home) income and multiply by 80%. This assumes that your family will live on 80 percent of your current salary if you’ve died. There are better ways to do this. Instead, determine what percent your family would need in the event of your death and use that percentage.

Divide this amount by .05. This means that you’ll need to peel off 5 percent to live on. This single number creates (again) huge assumptions. The biggest? It’s that you’ll continue to live on this income stream even as inflation skyrockets. Once again, we’re trying to get in the ballpark, so if you’re trying to do this the “quick and dirty” way, we’ll be close, but there are better ways.

Place your answer here: $__________________

Add up these 3 lines, that’s how much you need.
$__________________

Now, often, I’ve seen insurance salespeople stop at this point. Not good. Remember, you have some current savings! The goal of insurance in most situations is to replace income that you don’t yet have.

Subtract the amount of money you already have saved from the final number.

$__________________
Buy the difference.

Education Chart

Age$ needed todayAge$ needed today
0$78,855.8711$64,200.32
1$77,395.5712$63,011.43
2$75,962.3213$61,844.55
3$74,555.6114$60,699.28
4$73,174.9515$59,575.22
5$71,819.8616$58,471.98
6$70,489.8617$57,389.16
7$69,184.5018$56,326.40
8$67,903.3019$34,071.75
9$66,645.8320$23,139.91
10$65,411.6521$11,792.45

Later, we’ll have a discussion on the various types of insurance you should consider and the #1 question you should ask before you buy anything from any insurance sales person.

As always, this exercise is more about understanding the variables that go into making a good decision as much as it is about the final product. Plug in your own unique situation and evaluate many types of coverage thoroughly before buying life insurance.

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