Part 2 of Making A Million Dollar 18-year Bet

This is Part 2 of Making A Million Dollar 18-year Bet, a guest post by Platinum Sponsor Johanna Fox of Fox & Co. Wealth Managementt, a fee-only financial planning firm. Start as early as you can As Bonnie says, compound interest is the 8^th wonder of the world – you want to make it work in your favor. If you can afford to begin at birth, choose the most aggressive portfolio possible and contribute at least enough to get your state’s annual income tax break. Learn the rules in your state, too: some states allow tax breaks for contributions to other states’ plans and the cutoff for contributions vary: 12/31 in some states and 4/15 in others. Even if you can only afford to fund a minimal amount at birth, start with something as long as you are not compromising your retirement goals. In the Varkeys’ case, assuming 7.5% average return, choices include (not considering the time value of money):

• Frontloading the 529 with $108,859 (because they are allowed to frontload $75k/person, they can split the gift and fully fund college). OOP savings = $384,801
• Contribute $27,500/yr to the baby’s 529 for 5 years. OOP savings = $351,660
• Make monthly contributions of $818/mo. for 20 years. OOP savings = $297,380

Use ESAs for lower grades

Our couple hopes to send their children to private high school. In this case, we recommend they add Coverdell Education Savings Accounts (ESAs) in addition to 529s. ESAs are often overlooked because:

• Contributions are limited to $2k/yr per child and
• Those with income over $190k are phased out from contributing (but you can get around this).

But by saving $2k/yr/child in an ESA from birth and averaging 7.5% growth annually, your ESA would be around $50k when your child is 14. Why is this important? Because under the new tax law, 529s can be applied to private school K – 12, but only up to $10k/yr [Editor's note: Some 529 plans aren't allowing this 529 K-12 withdrawal at all or require tax recapture ]. An ESA would be a nice complement to the 529. But what about the income limits? Anyone can contribute to the ESA – even the child herself. You simply gift $2k into your child’s UTMA each year and transfer it to the ESA. To avoid the UTMA, gift $2k to a trusted family member in a lower tax bracket and let them make the contribution.

Underfund your 529s and ESAs

This may sound contrary to the key principle “start as early as you can”, but please bear with me and it will make sense. My goal is to use up all of the money in your tax-blessed accounts. Otherwise, in general, you’ll pay a 10% penalty on funds you withdraw that are not used for approved education costs. There are exceptions to the 10% penalty, such as if a child gets a scholarship, but not for just having money left over. Of course, you can pass account leftovers down the line to younger siblings, and we plan to do that, but I’m trying to keep it simple – say, you don’t need as much because your children decide to start out at a community college or want to go to a state school with a best friend, or, even worse, follow a boyfriend or girlfriend there. How can you possibly plan for that? To mitigate that risk, we recommend that about 75% of projected expense goes into ESA/529s, with the remaining 25% going into a taxable investment portfolio. When following this recommendation, start the taxable account only after you have funded the 75% in 529/ESAs, which will maximize your tax-free funding. If you end up needing the taxable account, you’ll be able to take advantage of lower long-term capital gains and dividend rates. If you don’t need the taxable account for education, voila! Can you say “beach home?” So what about med/grad school – what should the Varkeys do? At this level of income with 3 children, they will probably need to raise their family in a LCOL area of the country, plan to work extra shifts for a few years (if that is an option), determine to be extremely frugal, or save to fund a less expensive college experience – after all, they are saving for 6 educations. Possibly forego the private high school. Or they could save only enough for 50% of med school (1.5 educations instead of 3.) Remember, planning is about prioritizing how to allocate limited resources to achieve your goals. We’re back to priorities – what are your priorities about lifestyle and education? It’s very important to get those figured out in the beginning rather than simply saving what’s left over in your bank account each month. For example, one of our clients in this very situation has opted to set aside enough for med school for one child using the 75%/25% rule. If one or both of the other two siblings also decide to be physicians, then we are planning to have enough saved in a taxable account to also send them. This couple lives fairly frugally and in a LCOL area.

Finally, invest aggressively if you can self-fund

Here’s the way I look at it – if you can cash flow the early years, particularly private K – 12, then you should keep your savings invested in a well-diversified equity portfolio up until the time you need it. If the market is down, we would plan to pay cash for private high school in this situation. If the market is climbing, we’ll liquidate enough of the 529/ESAs to pay the tuition annually. The 75/25 rule comes in handy again to prevent you from over-saving. And, of course, you can allocate your own savings any way you want: 60/40, 80/20, and so forth. By thinking through your choices, resources, and priorities, and then following your plan, you will have a much clearer path to saving for huge expenses that seem too far away to even think about when your children are young. I hope this information has been helpful!]]>