Journal of Financial Planning: January 2020
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As virtually every American knows, the cost of college education is skyrocketing. Compared to medical care, housing, food, and general inflation, the price of a college degree is disproportionately rising.1 For your clients with college-bound children, the relentless increase in cost can cripple their budgets, now and in the future. Increasing tuition bills are creating a student loan crisis. Americans now owe about $1.5 trillion in student loans, more than two times what they owed a decade ago.2
Considering the reported financial value of a higher education degree,3 it should come as no surprise that saving for college is among parents’ top financial goals. When we surveyed more than 1,000 California parents with children under 18 who are hoping to help their children pay for college, nearly all of them (90 percent) said that helping their children afford college is “one of the most important things I can do as a parent.” And 52 percent said they would take on a second job if they had to, in order to help their kids afford college.
We also asked clients of financial advisers about their views of funding their children’s education. The results suggest that many families are stressed out about college funding, and those families are making at least one savings misstep that may be costing them thousands of dollars.4
- 31 percent said they lose sleep over how their child will pay for college.
- 44 percent are keeping their college savings in taxable accounts and paying avoidable taxes.
- 39 percent plan on using retirement savings to fund college expenses.
Most Advisers Aren’t Making the Grade
Many of these parents are making college savings mistakes in part because their financial adviser isn’t leaning in to help—he or she isn’t opening the conversation. Although most advisers would be happy to address these concerns if asked, the clients in our survey offered these views about the value their adviser provides when it comes to college savings:
My adviser is doing a great job on college savings (70 percent disagree).
I’m counting on my adviser to help reach college savings goals (76 percent disagree).
I consulted with my adviser about college savings investments (65 percent disagree).
I would recommend my adviser for college savings (74 percent disagree).
Clearly, many advisers continue to shy away from college savings discussions, perhaps due to the limited assets involved. If you haven’t put college savings at the top of your client priorities, consider that 529 plans can be an easy, effective solution that can help you expand your practice and grow your assets under management.
When chosen carefully, a well-designed 529 college saving plan can provide open-architecture investment options based on criteria favored by advisers; offer low-cost passive and active alternatives; limit the need for ongoing management with pre-packaged portfolios; meet your support needs with dedicated adviser professionals; and enable assets to grow free of state and federal taxes.
Are Your Clients Making These Mistakes?
Without support from their advisers, families saving for their children’s education will likely continue to make college savings mistakes. In fact, more than half of the families we surveyed are making at least one critical mistake when saving for college, potentially resulting in higher taxes, reduced financial aid, subpar returns, and diminished assets to invest for other purposes.
Mistake No. 1: Paying taxes on college saving income. If your clients are paying taxes on their college savings income, they could be missing out on up to 25 percent more money for higher education. Forty-four percent of the families we surveyed are keeping funds in taxable accounts and paying taxes that are entirely avoidable.
In a hypothetical example using the California ScholarShare 529 plan, assume an initial contribution of $5,000, monthly contributions of $50 for 18 years, and an average annual return of 7 percent compounded monthly for an effective rate of 7.23 percent. Tax calculations assume the maximum federal capital gains tax of 20 percent and the maximum state marginal tax rate of 13.3 percent. Taxes are assumed paid in a lump sum at the end of the accumulation period, and state taxes are not federally deductible.
At the end of the accumulation period, the taxable account would be worth $31,290. The 529 plan would be worth 25 percent more, or $39,049.
Solution: Make sure your clients take advantage of the tax-free growth opportunities for college savings.
Mistake No. 2: Clients are limiting their financial aid award potential. Given the high cost of college, some institutions are awarding aid to families with household incomes of $200,000 or more. Financial advisers should, therefore, not be surprised if some of their higher-income clients qualify for aid, especially if they have more than one child in school at a time. And with financial aid eligibility determined by the Free Application for Federal Student Aid (FAFSA), many clients don’t understand that their college savings choices can negatively impact how FAFSA views the family’s financial situation.
For example, 39 percent of parents in our survey said they plan on using retirement savings to fund college expenses. Those who tap their IRA may find this reduces potential aid by as much as 50 percent of the withdrawal each year. And a custodial account held by the parents of a student under UGMA/UTMA will be counted as a student asset, which can reduce the aid package by 20 percent of the account balance each year.
On the other hand, 529 savings plans typically have minimal impact on financial aid. These accounts are usually opened by parents, and the assets are treated as belonging to the account holder, not the student. This is important because student assets may be assessed at a significantly higher rate than parental assets.
The treatment of investments in a 529 savings plan varies by school, however. Any investments, including those in 529 accounts, may affect eligibility to obtain financial aid based on need, so make sure your clients check with the schools they are considering for details.
Solution: Help your clients plan ahead by choosing a savings strategy that is FAFSA friendly.
Mistake No. 3: Clients are keeping their money where it won’t earn enough. Many parents try to play it safe by stashing their college funds in a savings account or CD. These accounts are traditionally low-risk and relatively reliable, but they may fail to provide sufficient return to keep up with rising college costs. Your clients need to understand that this approach means the spending power of their savings could be significantly eroding every year.
You can illustrate this point to your clients with a simple example: the potential outcomes when $1 is saved over 18 years in a savings account or a five-year CD compared to a tax-free 529 plan.
In this hypothetical example using the ScholarShare 529 plan, returns are compounded continuously, and the tax calculations assume a maximum federal capital gains tax rate of 20 percent; a marginal tax rate of 13.3 percent; all taxes are paid at the end of the 18th year; and local taxes are assumed to be in excess of federal deductible amounts. Finally, the 529 plan’s tax status assumes that it is used for approved higher education expenses.
This example shows that the initial $1 saved in a 529 plan with 7 percent return and tax-free growth grew to $3.38, while the $1 saved in five-year CDs with 1.2 percent (taxable) returns grew to $1.16, and the savings account providing 0.1 percent (taxable) returns grew to $1.01.
Solution: Encourage clients to consider an investment account designed especially for college savings.
Mistake No. 4: Clients are paying more fees and expenses than necessary. Section 529 plans are designed for college savings, but they are all different. As with any investment vehicle, the performance, and the fees and commissions plans charge, can vary widely.
Strategic Insight, which provides wide-ranging data and services to the asset management industry, publishes a quarterly 529 Plan Fee Analysis report at sionline.com/PracticeAreas/529.asp. It’s a good place to start researching 529 plan costs. In addition, Morningstar publishes an annual analysis of the best 529 plans based on factors including plan cost and performance, and the top plans are awarded a gold Morningstar Analyst Rating.5
Keep in mind that although each state offers its own 529 plan, your clients are not limited to their own state’s offering. Instead, they can open an account in any state’s plan, though some may offer special benefits to state residents.
Solution: Review—and help your clients understand—the fees and expenses associated with different plans before selecting a 529.
Putting It All Together
Few goals are more important to clients than giving their children a solid foundation for success by putting them through college. Helping your clients realize this milestone is a tremendous opportunity for financial advisers. But when most clients aren’t counting on their advisers to help them hit their college savings targets, something is clearly amiss and an opportunity exists for financial advisers to prioritize college savings conversations. Doing so is likely to increase client satisfaction and inspire your clients to make referrals to family and friends. Above all, advisers who address their clients’ college savings needs are acting on the financial planning profession’s primary commitment to help clients achieve life’s most important financial goals.
Endnotes
1. See the Nov. 13, 2019 Advisor Perspectives article, “What Inflation Means to You: Inside the Consumer Price Index,” by Jill Mislinski. Available at advisorperspectives.com/dshort/updates/2019/11/13/what-inflation-means-to-you-inside-the-consumer-price-index.
2. See “5 Facts about Student Loans,” posted Aug. 13, 2019, by the Pew Research Center. Available at pewresearch.org/fact-tank/2019/08/13/facts-about-student-loans.
3. See, for example, “College Graduates Are 177 Times More Likely to Earn $4 Million or More,” by Derek Newton. Available at forbes.com/sites/dereknewton/2018/10/01/college-graduates-are-177-times-more-likely-to-earn-4-million-or-more/#1d402f712048.
4. Survey respondents were California families with average income of $140,000, using a financial adviser, and saving for their child’s college education.
5. See morningstar.com/articles/867032/the-best-529-plans for the 2019 rankings.
Julio Martinez is executive director of the ScholarShare Investment Board, which administers California’s ScholarShare 529 (ScholarShare529.com) college savings plan.