Saving for your children’s college education is a baffling array of acronyms and confusing account types like 529 or Coverdell. Just picking a type of account to fund can take a few hours of deep research, and that is just to get started. Once you choose the type of college savings plan, you have to decide what to do with the money inside the account. The college savings asset allocation will probably look very different from your retirement asset allocation!
You could, in theory, just let it sit there in a savings account earning simple interest. But the constant march of inflation would cut down the spending power of that cash drastically. (For example, if you put $1,000 into an account in 1993 and withdrew it 18 years later for your child to go to college, you would need it to have grown to $1,532.80 to just break even with inflation.)
Saving for college is not the same as saving for retirement. Let’s take a look at some strategies you can use to maximize your returns, while keeping an eye on your risk tolerance and investment timeline.
Saving for College: Two Key Factors
Saving for your kid’s college education comes down to two main factors: how much you save, and your asset allocation.
How Much You Save
The more you save, the better off you are in terms of providing adequate coverage for your children’s college education costs. You can’t set aside $10 and hope it grows to $50,000 over the next 18 years. Set aside as much as you can each year (or ideally each month) through automatic contributions. Over time make sure you are gradually increasing how much money is invested as your income grows.
Asset Allocation of College Funds
Once you have cash sitting inside a 529 college savings plan or similar education investment account you need to decide how to invest it. Do you take a risky strategy and pick individual stocks (not recommended!) or simply sit on the cash (also not recommended)?
You’ve heard of asset allocation from reading about retirement accounts and selecting what percentage of your nest egg to put into stocks versus bonds or cash investments. The same holds true. You need to decide how much risk you can stomach on the invested funds.
College Savings Asset Allocation Strategies
Here are three tips on setting up an asset allocation for education costs.
Assess Your Risk Profile
First you need to understand how you feel about risk. Are you likely to freak out if the market drops? Or do you see a buying opportunity? How you feel about risk will dictate how to invest funds. If you lean more conservative and risk-averse you need to pick investments with lower returns and less volatility. If you take the risk-averse path you may need to ramp up how much money you are saving each year to make up for the lack of risk.
Assess Your Need
The next step is to assess your need in terms of how much you are capable of saving for education compared to how much is needed. If you anticipate needing $100,000 in total for four years of college education costs 18 years from now, but can only save $2,000 per year for 18 years you will end up relying heavily on a strong amount of growth from those investments. (How strong? About 9.8% per year on average.)
On the other hand if you can save up $100,000 in cash over 18 years then you don’t need much, if any, growth from the investments and thus can take a much more conservative investment approach.
When to Invest Aggressively versus Scaling Back Risk
Your need and comfort with risk will — and should — change over time. You shouldn’t be 100% in stocks right before retirement and your kid’s college savings shouldn’t be 100% in stocks during their senior year of high school.
Phase 1: Growth
If you are more than 10 or 15 years away from needing to touch the funds then you can take a more aggressive investment approach. This is the growing stage of the portfolio and there is enough time to recover from downturns that being 100% in risky investments like stocks is okay.
Phase 2: Avoid Big Dips
As you get closer to needing to use the college funds — perhaps 5 to 7 years out — then it is time to significantly scale back the risk. This is similar to slowly lowering your exposure to stocks as you get closer to retirement. The big key here is to avoid any huge drops in the value of the portfolio due to a stock market drop. The more bond investments you have during a downturn the smaller the dent on the education portfolio. Without 10+ years ahead of you to repair the damage from a dip, your primary goal should be limited growth and avoiding significant losses.
Phase 3: Sit on Cash
Lastly as you get within 1-2 years of needing to use the funds to pay for school costs (and during your child’s enrollment in college), you don’t want any risk at all. You can probably get away with some small bond investments (especially TIPS which are backed by the US government), but mostly cash will be best. You are in the midst of using the money and can’t afford to risk losses from stock investments. Cash will lose out a bit to inflation over four years, but not a significant amount.