For parents of college bound kids, the month of October is usually centered around getting the FAFSA application completed and submitted with the slim hopes that for some reason the Federal government or the school their child will be attending might grace them with the gift of grants or low interest student loans.
We have all heard the stories of the eye-popping costs to send the average child to college. Having just launched a set of twins off to their freshman year at college, I can now tell you from experience - those stories are true! Some families get lucky if their child is exceptionally bright or athletic and are offered scholarships. Unfortunately, that is not the case for the vast majority of our college-bound kids.
As is the case for anything important in our lives, the best thing we can do for ourselves and our children is to start planning for this life event. Of course, the earlier the better, but it really is never too late to start. Even if you are only a few years from graduation day you can still give yourself a head start.
In 1996 the government established the 529 Plan account to help parents save for college. The 529 Plan is an education savings account that is designed to encourage families to save for college by offering tax benefits for the contributions and earnings to the account. 529 Plans are operated by a state and/or a financial institution. While most states have their own plans, anyone is free to open an account with any of the plans in place. There are some tax benefits that we will discuss if you open an account run by your own state of residence. It is also not a requirement that the beneficiary (child) be a resident of that state or attend a college in that state.
There are a couple of types of 529 Plan accounts:
● Savings Plans - this type of account allows you to save as little or as much money as you would like to put away (there are maximums that vary by state, but they are typically over $300,000 in lifetime contributions). There are different investment options that either you or your financial advisor can choose from. The account value will move up and down based on the market performance of the investment options that you selected.
● Prepaid Plans - this type of plan will allow you to pre-pay all or part of the costs of an in-state public university tuition. The funds can be converted to pay for use at a private or out-of-state college. With this type of account you are not making investment decisions. Why would someone want to put their child’s college funds into a 529 account instead of just a regular investment account? First and foremost, the biggest benefit of a 529 account is the tax benefits that the account owner enjoys throughout the life of the account. There are two types of tax benefits:
● Contributions to an in-state 529 Plan - if you open an account that is operated by your state of residence, many states (Illinois is one of them) will allow you to deduct contributions from your state taxes up to $10,000 per person ($20,000 for a married couple) per year.
● Tax-free earnings for the account - this is where the real tax benefit comes in. As long as the assets are used for qualified education expenses (we will discuss what is considered a qualified expense later), the funds can be withdrawn tax-free.
o Let’s do a simplistic example to show how much that could mean in savings. If you decide to start investing a $1,000 a year from the year your child is born until they go off to college, you would have contributed $18,000 to their college funds. If we assume the account grows by an average of 5% over the 18 years, the account would grow to approximately $28,000 by the time they are ready to go off to college. So we have about a $10,000 earnings gain. If those funds were put into a 529 account, the $28,000 could be withdrawn to pay for college, tax-free. If those funds had instead been invested in a regular investment account, when we went to withdraw those funds there would taxes due on that $10,000 in earnings. Even if we used the lowest tax rate of 15%, the taxes owed when making the withdrawal would be about $1,500. Again, this is a simplistic example for illustrative purposes only.
As you can see, the tax benefits can really add up over time.
The other benefit worth noting is that in an attempt to encourage parents to put money away for college, when the time comes to fill out FAFSA (financial aid forms), 529 accounts are treated much more favorably than a regular investment account. So when FAFSA calculates how much in assets a family has available to pay for college, they count 5.64% of the value of a 529 account versus a regular investment account where they will count 20% of the value.
Now let’s consider some of the potential issues that parents should think about before opening one.
● Let’s start with the most important one- fees. Whether you are working with a financial advisor or setting the account up on your own, make sure you understand what fees you are paying. Ideally, if you are working with an advisor they are charging you a discounted fee for investing in a 529 account. You will also want to make sure you are getting invested in the investment options that have the lowest underlying expenses. There can be a very wide range of fees that are charged to different investment options in a 529 Plan. Make sure you ask your financial advisor these questions.
● Given the tax advantages of a 529 account, many parents worry about what they would do with the account if there is a financial emergency and the family needs to access these funds for something other than their child’s education, or if their child gets a scholarship or may decide not to go to college at all. Let’s address each of these issues:
o If the account owner needs to access the funds in the 529 account for something other than qualified education expenses they will be required to pay income taxes, plus a 10% penalty on the earnings portion of the withdrawal. This is an important point to note because often times people think they will pay taxes and penalties on the entire withdrawal amount. It is only on the earnings portion that has accrued. But, no, you cannot choose to just withdraw the contribution portion of the account; the withdrawal will be a pro-rata share of the contribution portion and earnings portion of the account.
o If a child gets a scholarship or some other form of financial aid, the account owner can show proof of this aid and are then allowed to withdraw funds from the 529 account in the amount of the aid and will only have to pay income taxes on the earnings portion, but not the 10% penalty.
● 529 accounts will only cover qualified expenses. Expenses that are not considered qualified will have to be paid for with other assets. Qualified expenses include: tuition, room and board, books, and computer requirements. If the student lives off campus, then an average dorm rate at the college will be used to calculate an acceptable amount that can be withdrawn from the 529 account to be used for rent. Non-qualified expenses would be transportation to and from school, extra-curricular activities like club sports, or fraternity and sorority membership costs.
If you are a grandparent or other relative who is considering contributing to a child’s 529 account, you may want to open up your own account with the child as the beneficiary. When the time comes to apply for financial aid, non-parental accounts do not get included in the asset calculation to determine financial aid. Once these funds are used to pay for college, the amount used will be included in the income calculation to the child. Advisors typically recommend that these funds be used in the last year of college after all financial aid applications have been submitted.
When it comes to planning for college, my advice is to start as early as possible. Even if you can only contribute $50 per month to start, the benefit of time is in your favor. Take advantage of that. As a parent you will feel better knowing that you have started taking an active role in planning for your child’s future. It might make it a little easier to say ‘no’ to that toy that they don’t really need when you know that those funds are instead going towards their college education. Even if you know you are unlikely to fully fund your child’s college account by the time they are ready to go (which most people are unable to), I can say from experience that it feels a lot better to be able to explore your child’s options with them, without being hyper-focused on what the cost is for each school they are considering. It is an overwhelming and exciting time for your child as they enter this whole new chapter in their life. It is a gift to parents to be able to experience it with them and guide them through it. When you can plan for this life event in advance, even if it only gets them part of the way, it allows everyone to enjoy the process that much more.
With the recent market volatility that we have experienced since the start of the New Year, there has been some media speculation as to whether this is a repeat of 2008. While there are some significant unknowns in the global economy right now, it is a very different situation from 2008.
In 2008 we had a systemic problem with the U.S. housing market that affected every aspect of the housing sector. To begin with, homeowners took on too much debt. In 2007 households had, on average, debt levels that were 130% of their income. Today that number is 103%. The snowball affect of all that leverage impacted every aspect of the housing market, from homebuilders to mortgage lenders to real estate agents to construction workers, and on and on. In addition, the banks and lenders that held this debt through mortgages had to write off huge amounts of losses.
Today the market concerns are very different. There are two key issues that we are dealing with. The first one relates to the slow-down of economic growth in China. The world has become accustomed to decades of the Chinese economy growing at a very fast clip. Their rate of growth has slowed and the capital markets are trying to figure out what China’s ‘new normal’ will be. Uncertainty typically causes volatility in the markets.
The other key issue is related to the price of oil. There are very few people out there who anticipated oil going below $30/barrel. So while low oil prices offer consumers more disposable income to spend on other goods and services (which is good for the economy), at these prices there are a lot of energy companies that can’t stay afloat and could ultimately need to declare bankruptcy. The investors and lenders to these energy companies would feel the pain.
While these are not insignificant issues, they are not the systemic problems that we were dealing with in 2008. The overall market is near a correction (which is defined as a drop of 10% or more from it’s high point). Market corrections will occur and, while they never feel good, they are part of the investment cycle. We have included the chart that we sent out back in August just as the market turbulence of this summer was beginning. This chart is a good reminder that as long-term investors we are better served to look through the short-term noise that will always exist in the capital markets.
As many of you are probably aware, last week we experienced significant volatility in the global equity markets. While many speculate that it was due to the slowdown of economic growth in China, oil prices back to hitting new lows, and uncertainty over what the Fed will do at their next meeting, the reality is, we have not experienced much volatility in the equity markets in quite some time. Last week's move was the largest down market that we have experienced since 2011. While most investors would like the markets to move at a slow and steady incline, it is not realistic to expect that corrections will not occur from time to time.
None of us know at this point if this is a blip or if there is more downward pressure in front of us. We will only know this in hindsight. To provide some perspective on what has happened in recent history subsequent to major market corrections, please see the chart below.
This chart shows what has happened to the performance of a balanced investment portfolio 1,3, and 5 years after the markets responded to different global crisis over the last 30 years. In all situations a balanced investment portfolio would have experienced solid positive returns after a five year time horizon and all but one event had positive returns after a three year time horizon following a crisis (due to a second crisis occurring within the 3 year time period).
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The Swiss Nation Bank hasn’t been given the credit that they deserve. It is likely that their decision to let their currency float freely on January 15, 2015 will mark the turning point for the European economy. It was quite a shock to the currency markets for a couple of days that’s for sure. Since that day the Euro has declined by another 4% vs. the dollar. This is in addition to the 16% decline since the beginning of 2014 thru January 14th, 2015. This was probably not the intention of the Swiss National Bank, but they effectively provided a quantitative easing that just might pull Europe out of its economic malaise. A currency devaluation is exactly what Europe needed to provide a growth engine (i.e. exports since their goods will be cheaper to their trading partners) that they so desperately need. The European stock market index (Euronext 100) is up almost 11% since January 14th which signals that investors are seeing greater growth potential for European companies. When you consider the added jolt of quantitative easing that the ECB is throwing in with their promise to buy over 1 trillion euros of European bonds, it will be interesting to see if a recovery in Europe begins to take hold over the next several months. If this level of QE doesn’t work for Europe there might be another lost decade (think Japan) on deck.