How much to save for college?

I have been writing a lot about how to get into college and how to save for college. Now is the time to write about how much to save for college.  This is an important question to ask so that we are well prepared when it’s time to pay those tuition bills.

The first question comes to people’s mind is: should the children not pay for college themselves? By paying for their college, are we not setting them up for an entitlement trap? That’s a good question. I am of the opinion that the responsibility can be shared. I, as a parent, am willing to pay for my kids’ education, provided the kids exhibit good performance, discipline and an eagerness to share the burden.

How can kids share the burden? The kids can share the burden by working harder in High School and/or in the first years of college. There are many things they can do. Here are a few items (what works best depends on the temperament of the child):

  • Go to a community college for the first two years and then transfer to a 4-year school at the end of their sophomore year.
  • Take college credits in High School by attending a community college while also attending High School and then transfer some of those credits to their 4-year college. This requires understanding what classes their prospective colleges will accept.
  • Take AP (Advanced Placement)/IB (International Baccalaureate) classes in High School and transfer those credits to college when starting the 4-year program.  Again, which classes will be accepted at the prospective college, has to be found out in advance.
  • Enroll in a Middle College instead of a traditional high school in the 11th grade. This way, the child will earn a lot of college credits while in middle college. An example of such a program in my area is Tri-Valley ROP.

The moral questions aside, let’s run the worst-case and best-case numbers, provided you are a high-income family who will not receive any means based scholarship. I will write a separate post regarding the means based scholarship strategy.

Starting with worst-case:

Let’s say, my son who is 3 right now, will attend Stanford University (private, expensive school) when he goes to college at 18. I have already saved a lot for his college but for the purposes of this worst-case simulation, let’s assume that I am starting with ‘0’. Running the numbers on  Vanguard College Cost Estimator,

NirvanhCollege

Worst case scenario for someone whose child is 3 and will be going to Stanford eventually. 

It seems that I will need $407,640 to cover his cost of college. Again, assuming the worst-case that he does not receive any scholarships and he does not get any credits transferred, I will have to save $13,176 every year, invested in an index fund with 6% returns, while the college cost is increasing by 3% every year. $407,640 includes tuition, books, room, board and everything else.

Now, the best case:

Let’s say, my daughter who is 10 right now, first goes to a community college for the first two years and then transfers to an in-state school the University of California- Berkeley for the remaining two years. Let’s also say that somehow she manages to stay with us at home this entire time and also get’s some partial merit scholarship (say 25%), while at University of California- Berkeley (we live fairly close to Berkeley). The math will work out like this:

Cost for 2 years of community college eight years from now: $9180. Need to save $720/year for that in the 6% Rate of Return index fund.

FreyjaaCommunityCollege

Best case scenario for someone whose child is 10 and will be going to a community college first.

Cost for 2 years of University of California Berkeley: $36857 (tuition & fees only) Only $27,758 needed to cover 75% of the tuition if she gets a 25% scholarship. Let’s say I am starting from 0 (which I am not), I only need to save $1710/year to cover this.

If you are having your child now, you only need to save $348/year for the first two years of community college and $1176/year for the two years of UC Berkeley, totaling ~$1500/year.

FreyjaaCollegeFinal2Years

Best case scenario for someone whose child is 10 and will transfer to UC Berkeley for the last two years of college, also scoring a 25% scholarship. Note that I selected 20 for “Age Starting College”

Hence, in this best-case scenario for a family like mine, we need to save $2430/year for the next 8-10 years, if we are starting when our child is 10 years old and has everything working out for her. The total amount needed is roughly $37,000.

The worst-case scenario for a high-income family is that you have to save $13,176/year for the next 15 years if you are starting out when your child is 3 years old and has to stay on the campus and does not get any scholarships and goes to an expensive private school for all 4 years. The total amount needed is $408,000.

You can see that this is a big range $37K-$408K, so what should you target for?  Of course, the paramters I chose were a little arbitrary as well. For the purposes of this analysis, I chose the ages of my children and started with “0” as the starting point. I chose a 3% increase in college costs annually and I chose a conservative 6% index fund return. However, the important point is that you can use the tools above and estimate your target costs. You should first look at your target schools and their costs and go from there. In general, in today’s dollars, $90,000 is the average cost of a 4-year college degree at an in-state public school (room and board included) and the corresponding number for a private school is $200,000. It is worth highlighting that the average out of state cost at a public school will be roughly $160,000 in today’s dollars.  Now, depending on your children’s ages, you might have to save either conservatively or aggressively.

Let’s say your parameters are:

  • Average 4-year in-state public school.
  • Room and Board included.
  • No scholarships expected.
  • Starting when your child is born.
  • 3% increase in college costs expected annually.

Putting the numbers in a regular FV calculator in an excel spreadsheet will give you ~$153,000. (18 is the number of years, 1 is the number of terms/year since I am using annual rate increase)

College Cost
$90,000
3.00%
18
1
$153,219

However, assuming a more aggressive annual increase of 5%  in college costs, the numbers bloat to ~$217,000.

College Cost
$90,000
5.00%
18
1
$216,596

So, this is tricky. It is better to oversave than undersave. The right number depends on various parameters and you have to estimate those parameters based on your judgement and the information available and put them in some of the calculators suggested above.

My next post will be on how to win scholarships for college, so stay plugged in. Having high income works against you for scholarships and we will go over some of the options with both low income and high income.

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Financial Outlook 2018

2018 is here and people are excited about their families, careers and education. The underlying foundation of all these pillars is their personal finance. For most Americans, the foundation of personal finance is the stock market.

We have been talking lately about the asset bubble formation and the bloated P/E ratios. (For introductory readers, P/E stands for Price to Earnings ratio and is one of the many indicators of the value of a stock). To understand where we stand, I attended Vanguard’s Financial Outlook Seminar with the new CEO Tim Buckley, Chief Investment Officer Gregory Davis and Head of Corporate Marketing and Communications, Rebecca Katz.

Vanguard

CEO Tim Buckley, Chief Investment Officer Gregory Davis and Head of Corporate Marketing and Communications, Rebecca Katz

Let’s look at various areas of the market as was discussed at the meeting.

P/E Ratios

While the panel members agreed that the cyclical P/E ratios are high at around 31, they also mentioned that under the light of low interest rates and low inflation, this is not over the top. (People are willing to pay more price for future earnings since the Future Value of Money is good in a low interest, low inflation environment)

Equity Outlook

The panelists suggested that they are looking at around 4.5%-6.5% for annualized return over the next 10 years. For 2018 specifically, the probability of recession stands at mere 5%, a mild recession at 10% and a slowdown at 15%. On the other hand, odds for the Trend to continue lie at about ~20% and the odds of growth lie at about ~50%.

Fixed Income Outlook (Bonds etc.)

The panelists pinned the 10-year annualized outlook for bonds at 2%-3%, mostly for high quality Corporate and Government bonds. Since the current interest rates are low, long term investors are encouraged to invest in short/intermediate term bonds since when the coupons mature, they can be reinvested in the higher yield bonds.

Diversification

Unsurprisingly, the panelists suggested that you should have a good mix of equities and fixed income vehicles so that if and when the market dips, you could trade your bonds with new equities. We will cover international market later in this article.

Inflation

An uptick in inflation is expected. However, it will depend on whether new money goes towards hiring more people (inflation increases) or incurring capital expenditure or financial engineering. Inflation is in check, thanks to some extent to technology because with technology, you can get more with less.

Interest Rates

The FED has indicated that it will increase interest rates in the next two years. Somewhere between 40 to 80 basis points in increase is expected.

GDP Growth

Again, unsurprisingly, the panelists mentioned that a GDP growth of ~2% in the US is expected.

Unemployment

They asked to watch this closely since unemployment is at a multiple decade low. This could lead to increase in wage pressures or using of more technology to replace humans (more capital expenditure).

Tax Cut/Bill for corporations

Begets the same question. Will the additional money  be used towards Financial Engineering (buyback stocks, a sugar rush of not much use) or expanding businesses and hiring, to increase the income potential of the corporations. However, the deficit generated is of concern because it reduces US’s credit rating, by increasing US’s debt/GDP ratio. This would mean that US will have to pay a higher interest on its new debts. Hopefully, the country does not get caught in a vicious debt cycle where a higher interest debt is serviced by another high interest debt.

Bitcoin/Crypto-currency

Vanguard will not offer anything with Bitcoins/Crypto-currency since it is a speculative thing like Gold. There is no underlying income stream/potential. However, the underlying “Blockchain” technology is being closely watched.

International Market

  • Europe
    • Affected positively by Global Economy.
    • Less political uncertainties now, leading to better valuation.
    • ~2% GDP growth expected.
  • China
    • A cooling off expected.
    • China is moving from capital intensive economy to consumer society. Capital intensive economy leads to better GDP growth, hence a fall in GDP growth to a level around 6%-6.5% is expected.

I hope I was able to convey the 2018 outlook in layman terms. Please let me know if you need further clarifications.

Happy investing!

The Mother of All Personal Finance Hacks- Mega Roth

I am writing this specifically for Jonathan and Brad. This was one of the finest finds for me in the personal finance space and I want the community to take advantage of it ASAP. In my other posts Simplifying saving for college and How to get your money into Roth IRA even when IRS prohibits it? , I talk a lot about how to get more money into Roth IRA. This is especially very important for the people who have already maxed out all pretax contribution opportunities like pretax 401K, HSA etc. This is the last post in the series.

MegaRoth

Who should do it?

Let’s say you have reasonable high income and you already do the following:

After doing all the above things, if you still have money leftover to invest, please don’t invest it in a taxable account. Instead, invest it in Roth IRA via the Mega Roth because Roth IRA has some major advantages. (see Simplifying saving for college).

How does it work?

A Traditional 401K has a contribution limit of $54,000 (first surprise! most people think it is $18,000). Here are the usual ways money goes into your 401K.

  • Your pretax contribution- $18000 limit in 2017.
  • Your employer’s matching- different companies have different rules.
  • Your after-tax contribution (let’s call it ATC).

ATC is where the magic happens. In a hypothetical example for Mr. Kirti, here is the breakup.

  • Mr. Kirti contributes $18,000 of his pretax income to 401K.
  • His employer matches $9000. (again, goes into account as magic pretax money)
  • Mr. Kirti makes another $27,000 ($54,000- $18,000- $9,000) of ATC.

What happens to the 27K worth of ATC?

  • It can be left there till retirement. Not very advantageous because money does not grow tax-free (unlike Roth IRA).
  • Can we rolled over into Roth IRA called the Mega Backdoor into Roth.

Can I do this as well just like Mr. Kirti?

  • Not everyone’s employer’s 401K allows this. Your plan needs to allow something called In-Service distribution since you are still working at the company.

How often can I do this?

  • Mr. Kirti’s 401K administrator allows him to take one In-service distribution every 12 months. But your plan might have different rules.

How should I go about doing this?

  • Call your 401K provider and ask them about In-service distribution. If they allow it, go to the next step.
  • Ask them the number of such distributions allowed and any costs associated with it. If any number of such distributions are allowed without any costs, take these distributions after every paycheck. You will most likely get a check for “<company which holds your Roth IRA>  for the benefit of <your name>”.
  • If they allow only one such distribution every 12 months, then try to make your after-tax contributions into the 401K in a shorter interval of time. Eg. make ATCs around bonus time or make the maximum allowed (% of your paycheck) ATC for some consecutive number of paychecks till you reach the max cap. The reason it is important to cluster it in such a way is because your contributions might grow if left in the 401K account for long and you have to understand what happens to the growth.

So, what happens to the growth?

  • First, you decide if you want to have growth or not while your money is sitting in 401K, waiting to be rolled over to Roth IRA. You need to decide because the growth can lead to a taxable event (it matters when you are trying to keep your Modified Adjusted Gross Income-MAGI within a certain level).  Mr. Kirti likes to let it grow since in his case, “growth minus taxes” is still superior than “no growth and no taxes” because he cannot possibly benefit very much by keeping his MAGI low by relinquishing real growth since he won’t be eligible for any benefits anytime soon.
  • If you don’t want it to grow, just put it in a Settlement account (usually money market) in the 401K and when the roll over into Roth happens, there is no taxable event.
  • If you invested it in the stock market, it might have grown. Now you decide how you want to handle the growth.
    • Take it to Roth IRA: Taxable event- you pay the taxes on the growth portion that year.
    • Move the growth/earnings portion into Traditional IRA:  this makes sense for people who never intend to do the regular Backdoor Roth because if and when they do the regular Backdoor Roth, they will have a big taxable event. If you intend to separate out the In-service distribution between contributions and growth, make sure you know the respective amounts (your 401K provider tracks the cost basis of the ATCs).

That’s it. If you have any more questions, ping me via the blog or pester Brad and Jonathan. Let me know how it goes for you and feel free to provide constructive feedback.  Happy investing!

 

 

 

 

How to get your money into Roth IRA even when IRS prohibits it?

In my previous article on Simplifying saving for college, I talked about getting your money into Roth IRA since its one of the most flexible tax advantaged retirement vehicles. However, IRS has an income limit restriction. They will not let you contribute if your Modified Adjusted Gross Income (MAGI), married filing jointly, is greater than $196,000 (2017 number).

Roth

Then, how do we do it? We take advantage of a tax loophole where conversions from other Retirement accounts to Roth IRA is possible.

Let me tell you step-by-step as to how I do it. I use Vanguard heavily since the cost structure of Vanguard is pretty solid and they have extremely low expense ratio for most of their funds (I can get into more details of Vanguard in a different post). The trick is that I don’t have a Traditional IRA with loads of money in it. This is the bedrock of conversion methodology. This is because when you convert from one Retirement Account to another one like Roth IRA, it leads to a taxable event. If you have plenty of pretax money lying around in a Traditional IRA and if you convert it to Roth, it will lead to a big tax bill that year (Even if you contributed to Traditional IRA with post tax dollars, the growth/earnings portion will trigger a tax bill). Below are the right steps to achieve the most optimal results if you don’t have money lying around in an existing Traditional IRA.

  • Open a Traditional IRA with Vanguard if you don’t have one.
  • Contribute $5500 (the contribution limit in 2017). Buy whatever fund you desire.
  • Open a Roth IRA with Vanguard if you don’t have one yet.
  • Once the funds have settled into the Traditional IRA (takes a couple of days or so), ask Vanguard to convert the funds to Roth.
  • The important point is to do it ASAP after the funds are available to be converted because you don’t want the money to grow before it reaches Roth; otherwise you will have to pay taxes on the growth.

This technique is called “The Backdoor Roth”. I don’t know how long this loophole will last, hence make hay while the sun shines.

Of course, the best advice here is for people whose MAGI (married filing jointly) <$196,000, please open a Roth IRA right away and start contributing directly to Roth instead of using the Backdoor hack. IRS starts phasing out the benefits beyond the MAGI (married filing jointly) of $186000; hence you won’t get to contribute the full $5500 between $186,000 and $196,000. If your MAGI (married filing jointly) lands below $186,000, you get the full $5500 to contribute.

Eventually, I will write another post where I will tell you another trick about contributing to Roth. Meanwhile, keep reading and start saving!

 

 

 

Simplifying saving for college

CollegeSaving

College is expensive in United States and parents need to be planned so that they are not surprised with the bill when its time to ship the kids to college. They might be thinking good riddance after dropping them off at the campus but not so much when the hefty sometimes even $50,000/year bill arrives in their mail. Scholarship is hard to get if the parents have high income, even if the student is meritorious, at Tier 1 institutions. Here are my tips for my US parents:

  • Avoid big student loans if possible. They will hunt you till your grave if you don’t pay them back. It is highly irresponsible to not pay back your loans in the first place but unlike other loans which go away if you file for bankruptcy, student loans don’t.
  • Roth IRA : Roth IRA is the best investment vehicle ever. Here are the things you need to remember about withdrawing from Roth IRA. My advise is to only use the contributions (not the growth/earnings) for funding college and I advise to use this as your primary college fund:
    • You can withdraw the principal (your after-tax contribution) anytime without any restrictions.
    • You can withdraw the growth, tax and penalty free if you meet the following conditions:
      • Roth IRA account has been open for more than 5 years. AND
      • It is a qualified distribution which means:
        • You are over 59 1/2 OR
        • Death or Disability strikes OR
        • First time home buy (a lifetime limit of $10,000) for the account holder, account holder’s children and grand children.
    • You can withdraw the growth, penalty free (but not tax free unless you are older than 59 1/2) if it is for college. You will pay ordinary income taxes on the amount of growth you withdraw for college. I do NOT advise touching the growth for college though unless absolutely necessary. This exception withdrawal does not have to wait for the 5 year period as discussed in the previous bullet. The college fee and tuition can be paid for the account holder, account holder’s spouse, children, grand children, great grand children etc.
    • Advantages of using Roth IRA
      • The contributions are flexibly available and if you don’t touch the earnings, they grow tax free.
      • Assets in Roth IRA are not used in calculating the Expected Family Contribution on the FAFSA (Financial Aid Form).
    • Disadvantages of Roth IRA
      • If your income is low and you could potentially qualify for Financial Aid/Scholarships, the amount of contributions which you withdraw, even though it won’t be taxed again, is still considered untaxed income on FAFSA (Financial Aid Form) and reduces eligibility for next year’s financial aid. The strategy will be to withdraw the amount a couple of years ahead of time called Prior Prior Year- PPY (losing the opportunity of growth for two years in hopes to qualify for financial aid/scholarships).
      •  There are usually income limits for Roth IRA contributions. People like me in the high tech industry don’t qualify to contribute. However, there are some loopholes which you can use. I will not list them here. If you are interested, you can either ping me for a friendly chat or read up online.
  • 529 Plans
    • Use it as the secondary college fund.
    • After tax money goes into the fund and grows tax free.
    • Disadvantages
      • Can only be used towards post-secondary education at the universities/colleges approved in your plan. If not used for post-secondary education, you have three options:
        • Change beneficiary to somebody else in the family.  Qualified beneficiaries are:
          • The designated beneficiary’s spouse
          • The designated beneficiary’s son or daughter or descendant of the beneficiary’s son or daughter
          • The designated beneficiary’s stepson or stepdaughter
          • The designated beneficiary’s brother, sister, stepbrother or stepsister
          • The designated beneficiary’s father or mother, or ancestor of either parent
          • The designated beneficiary’s stepfather or stepmother
          • The designated beneficiary’s niece or nephew
          • The designated beneficiary’s aunt or uncle
          • The spouse of any individual listed above, including the beneficiary’s son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law
            Any individual for whom the home of the designated beneficiary is his or her primary home for the entire tax year
          • The designated beneficiary’s first cousin
        • Leave it intact for your child’s graduate school or college later or your own education at some point in time if you are thinking of going back to college.
        • Withdraw the leftovers. You will pay ordinary income taxes on the earnings and will also pay 10% federal penalty tax on the earnings portion (a state penalty might also apply).
      • Assets in 529 are used to determine EFC (Expected Family Contribution) on FAFSA and reduce Financial Aid Eligibility.
    • Advantages
      • Both contributions and earnings are available to pay for college without taxes or penalty.
      • The withdrawal from 529 does not show up as income in that year for FAFSA purposes since the EFC has already taken care of including these assets in its determination, so no double counting.

I know all of this can be a bit too much but I have excluded many unnecessary things which confuse the parents. I don’t hold myself to any liability claims for this advice. Please talk to your financial advisor before making any contributions/investments. This is just a friendly advice and not a certified financial advisor’s advice.