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Saving for College with a Savings Account

I recently ran across a post on ING’s We the Savers blog in which the author explains his plans to save for his kids’ education:

“What do I do for my kids? Play Russian Roulette with the market and pray there’s enough for them to pay for books?

I’ve got a better idea. I figured that if I start saving $50 a paycheck for them in an Orange Savings account, they’ll have almost $50,000 to do whatever they want to with when they turn 18. Not too shabby.”

He’s saving for his kids’ education, and he’s getting started while they’re young (they’re 3 and almost 1). So thumbs up to him for that. But his specific saving plan leaves something to be desired:

  1. It neglects to take advantage of any of the types of tax-advantaged accounts that would provide better tax treatment than a taxable savings account.
  2. It uses a short-term investment (cash) for long-term needs (college 15 or 17 years from now).

Tax-Advantaged College Savings Accounts

There are 3 primary types of accounts that could be used to save for college in a tax-advantaged way:  529 plans, Coverdell accounts, and Roth IRAs. They each have their pros and cons (discussed more thoroughly in the article I just linked to), but any of the three is likely to come out ahead of a taxable account.

Everything in a Savings Account?

In the quote above, the author clearly indicates that he’s uncomfortable taking on stock market risk. Fortunately, there are ways to earn higher returns than a savings account without having to take on such risk. In fact, if college is 15 years away, there’s a way to earn returns that are both higher and more predictable.

Specifically: Buy Treasury Inflation-Protected Securities (TIPS).

Because they’re not as liquid and because they experience short-term fluctuations in price, TIPS generally offer higher returns than savings accounts. For instance:

  • If you were to purchase a TIPS maturing in January of 2025 (i.e., shortly before a child who is currently 3 would be going to college), you would get a 1.968% after-inflation yield.
  • In contrast, an ING savings account is currently only paying 1.1%, and that’s before accounting for inflation.

Not only can TIPS offer a higher return, but their returns are more predictable. Savings account returns are not predictable over long periods because:

  1. Savings yields can change at any time, and
  2. Inflation isn’t predictable (that is, even if you did know you’d get an X% yield over the period, there’s no way to know what the real, inflation-adjusted return would be).

In contrast, if you purchase TIPS with the appropriate maturity, you can achieve a (mostly) predictable inflation-adjusted return.

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  1. Trying to relate this to yesterday’s discussion, wouldn’t the above be a good argument against keeping large amounts of cash (say, even 3 years of expenses during retirement) as well? If cash is best thought of as a short-term reserve, wouldn’t you want to just have enough for liquidity in case of emergency, and you could keep a good portion of your portfolio in a TIPS fund with little risk and greater reward?

  2. The problem with TIPS funds for funding short-term needs (anything within the next 3 years, for instance), is that they fluctuate in value–sometimes significantly–as a function of changes in market interest rates.

    I think TIPS funds have a place as a diversifier in a portfolio, but if you’re looking to fund a specific expense on a specific date (i.e., college in a certain year), then an individual TIPS makes more sense because you can (roughly) match the maturity to the date you plan on spending the money.

    And as to using TIPS to fund ongoing spending needs, it could work if you could set up a TIPS ladder, with a TIPS maturing every month to pay that month’s bills. Unfortunately, there just aren’t enough different TIPS maturity dates to make that work.

  3. In the state we live, IL, Bright start manages 529 account and they have index funds for age based portfolio which have very minimal expenses. I have my daughter’s (2 year old) 529 with them.
    Iam not sure with a decent 529 account like this, if there are better alternatives. I would be interested and a may be a little surprised (naively).

  4. @SJ

    I personally like the 529 plans but you don’t necessarily want to go with your state’s plan… There are two factors to consider the plan’s fees and the break you may get on your state taxes. For example I’m in TX which has no state income tax and the fees of the TX plans are kind of high. I did some research to find low cost plans- Initially I was in Missouri but the plan management changed and went from a low fee plan to a high fee plan so I switched again to a plan in Utah. The point is that you have to periodically research it to insure you are still in a good plan.

    -Rick Francis

  5. “There are two factors to consider the plan’s fees and the break you may get on your state taxes.”

    Rick, Thanks for your view point. Both the above apply in my (IL) case. However, like you mentioned, I will keep an eye on the account as long as Iam in IL to watch out for any surprises.

  6. Niklas Smith says

    An excellent point about TIPS – investing in one that matures when you expect to need the money gives (nearly) complete certainty*. In the UK the same applies to index-lined gilts (UK government bonds), except that they have the added advantage of being free of capital gains tax even outside a tax-efficient wrapper. I hope you made this point in the comments to that blog 🙂

    *Short of the US federal government defaulting, fiddling of the inflation index à la Argentina or worldwide nuclear war breaking out.

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