Investing for retirement is one of the staples of financial planning. Almost everyone will either choose to, or be forced to stop working at some point, and having money set aside to fund these non-working years is important. In addition to retirement, there is an increasing trend in saving and investing for college expenses. College tuition is increasing rapidly, and many parents are looking to provide some relief so their children aren’t burdened with tens of thousands of dollars of student loan debt after graduation. With the creation of Section 529 plans, more people are aggressively saving money for college, and now have the opportunity to not only receive tax breaks for doing so, but they can put this money to work with various investments. But with these options and benefits come some drawbacks and things to watch out for.
Understanding Time Frame
One of the greatest factors that determine how you should be invested has to do with time frame, or time horizon. Knowing how long your money has to grow will largely dictate what type of investments you choose. But when it comes to investing for retirement versus college, while it appears simple, there is more to consider than looking at how many years you have left.
With retirement, most people have a lot more flexibility. For one, retirement age comes at different times for different people. Some retire in their 50s, while others work into their 70s. So, just because you’re 30 years old and expect to retire at 65, that means you have roughly 35 years, but it also means there is flexibility. Who knows what will happen over this time, you may retire early, you may be forced to work longer, or you may change careers. Whatever the case, you have the flexibility to take on some risk with your investments.
Looking at college savings, there is much less flexibility and the time frame is more rigid. If you have a child, you know that from birth, you have roughly 18 years until college. On top of that, you know that once they enter college, they probably have around 4 years in which they need to withdraw funds from the account. Sure, some children might get scholarships and not need the money, others might wait a year or two before attending college, or some might go on to earn a graduate degree. But for the most part, there is a fairly specific time frame at work which can limit the amount of risk you’re willing to take.
Why This Affects Investment Decisions
With 18 years of growth, and about four years of withdrawals, most people would see no problem with investing fairly aggressively, especially in the early years. This is to be expected, because stocks generally do produce high returns, and with that much time for the money to grow, you can weather the ups and downs. Even so, when you go back to the flexibility of extending your time horizon or putting off withdrawals, you really don’t have that as a luxury when it comes to college savings. What happens when your child is ready to head off to college and your account is down, are you going to tell them they have to wait a few years before they can start college so your investments can recover? Of course not. And if you wait too long, your window for using that money without taxes and penalties may be gone. You’ll likely have to settle for selling at a loss and maybe even foot more of the tuition bill yourself.
As you can see, even though there is more certainty in regards to how much money you’ll need, what tuition will cost, and knowing exactly how long you have to invest, it doesn’t remove any of the risk. While retirement may yield many unknowns, you at least have options in which you can plan for, and structure your retirement to make everything work.
You also have to consider the withdrawal phase. Like I mentioned above, for most people, withdrawing funds from a college savings plan will take place over a relatively short amount of time. But when you look at retirement, the withdrawal phase can span 20 or 30 years. This allows you to remain invested, at least in part, in stocks even while in retirement because you have another few decades in which you are slowly withdrawing the funds. With college, again, you need to depend on that money over just four or five years on average, so the need to safeguard those funds leading up to, and once the child is in college is very important.
How to Invest Your College Savings
When it comes to investing for college, many of the same rules apply as investing for retirement. But what really changes is the amount of time you spend in each investment phase, and ramping up to a more conservative portfolio earlier. To see why, just take a look at what the past 10 years has shown us. Over the past 10 years, the S&P has a negative annualized return. 10 years may account for half, or even more of your entire time to save for college. That could have a significant impact on how much money you are able to accumulate. So, here are some guidelines:
Birth to Age 5: Just like someone that’s just starting to save for retirement, it’s a good time to be investing in stocks. At this point, a diversified portfolio in stocks would be fine. You’d probably focus on primarily holding domestic large-cap stocks while rounding it out with some international and small or mid-cap offerings.
Age 5 to 10: At this point, you’ll already want to start getting a little more conservative. You’d probably want to think about a 70% mix of stocks and and 30% in bonds. You’ll want to stay diversified across the spectrum of stocks, and probably focus on something like intermediate term bonds.
Age 10 to 15: By now, you’ve crossed the halfway point if you’ve been investing since birth, so it’s time to ratchet things down a bit further. A 50/50 mix of stocks and bonds is going to be the name of the game for the next few years. You’d want to still keep a broad diversification of stocks, but you’ll also want to add some higher quality bond holdings. Of the bond portion, you’ll probably want to keep half of it in low-risk areas like a money market or fixed account.
Age 15 to 18: As you approach the home stretch, you want to make sure that any sudden market declines won’t completely drain your account since your child will be starting college in just a couple years. Three years isn’t enough time to rely too heavily on market conditions, so you will probably want to rely on a 75% allocation of bonds, and 25% in stocks. Now, you should begin to focus a little more on safer, income producing stocks, and shift towards more high-quality bonds. Remember, since you need the money in just a few years, you’d rather have a meager 5% gain than a 5% loss each year heading into college.
Age 18+: Your child is probably ready to start college, and that means the first tuition bills are due. Now is not a time for surprises, so you should be focused on generating predictable income from your investments. At this point, your investments are more or less a savings account that will regularly be tapped into. So, most, if not all of your investments will be in very safe things like money markets or fixed accounts. It’s still fine to keep a little money in the stock market to try and keep up with or beat inflation, but you probably don’t want more than 10% at risk.
Keep in mind that these are just guidelines, and by no means absolute terms. Economic conditions, interest rates, and the number of children you have and what their goals are will largely dictate exactly how you invest. But, this is a good starting point. If you’re able to begin saving and investing right from birth, that’s great. But keep in mind that if you don’t start until your child is older, it can be like playing with fire if you try to accelerate your returns by being more aggressive. Remember, just one or two bad years of returns could wipe out a year’s worth of tuition, and you have a limited amount of time to recover.
I’ve been meeting with a lot of people lately who started saving for their child’s college in just the past few years, and they have 15 year olds while they are invested entirely in stocks. It’s certainly not very fun to see your college fund cut in half in just a year when your child has just a few years to go until needing the money. So, it pays to be a little more conservative, especially in the remaining five or so years leading up to college so there aren’t any surprises.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
This method of investing in stocks earlier in the procedure, and switching those investments to bonds through the process, appears to be a solid way to match risk taken with the time left in the investment process. Getting to the point of a college education being provided is a larger item than one might think when hearing about it.
Stocks are an easy way to make passive income. A stock in investing terminology refers to one share of the ownership of a business corporation. If you own one or more shares of a stock, then you are entitled to your share of the company's profits, whenever the company makes a profit. Conversely, if the company loses money, the value of your share of the company decreases. Assuming you have money to invest, all you have to do is buy one or more shares of stock, and sit back and let the market do its thing.
As a college student, I see many peers go away to school at small liberal arts colleges and pay $30k a year in tuition. I just don't understand why people always overlook state schools. Sure, they might not be your ideal situation, but isn't it better than the $100k of debt later on down the line? Sure, my school wasn't my first choice, but it's still a top 50 school for my degree (finance), and I pay $3.5k a year in tuition, total.
Great article, I think so many people focus on the mechanism by which they invest rather than how that mechanism is affected by your time horizons. I think that with your financial background, you're able to step back and see everything so it's good you're sharing that wisdom here. The timeline is a nice added touch.
I'm emailing you in regards to a followup email I sent you a month ago in response to a partnership, have you had a chance to think about it?
If you have any questions or would more information, please advise me and we can go from there.
I'm far from investing for my kids college fund, considering I'm not planning to have any for quite some time. I definitely would take your advice to invest the money that I would've otherwise just tied into a savings account.
Have you considered residual income, like a blog or small investment, to help ease the woes of college spending. I look at my retirement more like: how much money would I need in a month to live how I want to live in retirement? I see $8000/month, rather than a lump sum like $300,000.
@Jeremy: True, I agree that there is a risk in any investment strategy. I guess it's what makes it so hard to make those major financial decisions difficult but also rewarding when they work out as we planned. Overall though, nicely put - I'm sure a lot of people can benefit from your suggestions and I hope they do.
@ToughMoneyLove - That's a good point. In reality, most people do this to some degree anyway. People rarely save up enough to fully fund college, and it typically means they have to adjust their cash flow to pay some of the bills. But, the unfortunate thing is most people don't plan for this early enough.
@Aya - The current market conditions certainly cast doubt on the effectiveness of investing, but even so, people who plan accordingly and take on only enough risk as they need to achieve their goals are still in good shape.
And sure, there are plenty of safer alternatives, but when you avoid one type of risk, you only take on another type of risk. You can save money outside of the stock market and eliminate market risk, but then you increase the risk of not saving enough, interest rate risk, inflation risk. If you avoid accounts like 529 plans, you lose out on tax-deferred growth and tax-free withdrawals, and in many cases, even tax credits on contributions.
So, to be sure, there are plenty of alternatives and ways to accumulate money for a specific goal, but you have to weigh the pros and cons and determine if you're really reducing risk, or just shifting towards another type of risk.
If only investing money could actually go as smoothly as organizing the plan! My skepticism might just be coming from the recent state of the economy, and I wonder how high the risk is in following your advice completely. Are there safer measures that can be taken, even if it might take more time and effort?
I think when saving money for college, one needs to have a more diversified portfolio with less risk. This is a shorter period of time than your actual retirement savings so one needs to make sure that their money pretty much is on a gradual increase over time.
Let me throw another option out there that most people do not consider: Plan on paying for some (or all depending on college) out of regular cash flow. This is what we have done and are doing with our 3 sons. Of course, this requires "consumption smoothing" planning early on, which is a huge topic unto itself. But it is an important one because so many people look at college saving and retirement saving as an attack on their consumption lifestyle, which creates negative incentive towards planning.