Your little one might still be a little bun in the oven, but it’s never too early to start thinking of college. Let’s help you out.
Dreaming of Baby speaks with Erika Jensen, President of Respire Wealth Management in Houston, Texas, on healthy family financials, and the how and why of saving for college.
Daniela: Good morning Erika, welcome to Dreaming of Baby! We’re excited to discuss with you the financial side of preparing for baby, parenthood, as well as that one worry that looms in many parents’ heads: paying for college. Before we start with our discussion, it would be great if you could introduce yourself to our readers.
Erika Jensen: My name is Erika Jensen. I previously worked for a large broker-dealer as an advisor and also served in a role called a “Financial Wellness Specialist.” I’ve traveled around the country speaking to large groups and recognized that often, the people who need advice the most think that they can’t afford it or don’t know where to look. So I started respire to provide high-quality investments to investors with all account sizes and goals-based advice even when people aren’t ready to invest.
The financial considerations you should make before baby
Daniela: Thank you for that background; as you know we are focused on aiding parents-to-be on their journey to parenthood. For our readers who are dreaming of baby what would you say are the major considerations they should be making when it comes to their financial health prior to having a child?
Erika Jensen: I’m a mom. when my son was born my husband and I had not been planning to have a baby. I didn’t think it was the right time. Then my mom told me, “there’s never a right time.” Babies are a wonderful blessing. Regardless of how financially prepared you are, you can make it work. That said, if you have time to prepare and are planning, you’ll be better off for it. I can’t emphasize enough that people should save. Saving is the key to a strong financial foundation and prevents high levels of revolving credit card debt. Second, evaluate health care plans. If both parents work, check to see which plan will be best for covering the baby’s health. Also, evaluate co-pay plans versus high deductible plans as they relate to your personal financial situation. Babies tend to lead to a lot of high-cost hospital visits in their first months, so be sure to check out of pocket limits in all plans available. If you don’t have access to employer plans, then evaluate your private plan and consider shopping for one that will cover maternal and neonatal care in a way that’s more affordable. Register for everything on your baby registry and make sure you have a baby shower. Evaluate the cost of maternity leave, child care, when or if you’ll go back to work. Prepare for plans to change. A lot of mothers end up changing their minds and deciding to stay at home. Savings can give you more flexibility when circumstances beyond your control cause changes, or when you cause changes. Be prepared to re-evaluate your budget. Remember that a budget is limited to your income. If your income is going to decrease, or if your expenses will increase due to baby (which will definitely happen), you’ll need to reassess some priorities and update your budget.
Erika Jensen: “Babies are a wonderful blessing. Regardless of how financially prepared you are, you can make it work. That said, if you have time to prepare and are planning, you’ll be better off for it.”
Options for saving for college
Daniela: Very interesting, important considerations. A lot of parents also think about the later years early and we have received a lot of questions about putting money aside early for college. What options are available to help with this?
Erika Jensen: The first thing I have to say about college savings is to establish a 529 plan early and tell everyone in the family to contribute. There are other savings vehicles for baby, but in terms of tax deferral (I have to give the caveat that I’m not a tax advisor, one should be consulted and this is for information only), calculations used in financial aid, and annual savings limits, 529s are the most effective savings vehicle for college. One important note for parents: it’s important to have your own emergency savings set aside, debt paid off, and contributions going into a retirement account before you personally start making massive contributions to a 529. That’s my absolute order for prioritizing savings. if you don’t have emergency savings you are guaranteed to have credit card debt and paying credit card debt is a huge guaranteed negative rate of return. It will negate any benefit of having a 529. Also, unless your plan is for your kid to go to college, get a great job and support you in retirement, you really need to focus on your retirement account before college savings. There are lots of ways for kids to pay for college. My husband used the GI bill. It’s easy for people to lose sight of where their priorities should be when baby comes along. Just remember those rules.
Erika Jensen: Anyone can contribute to a 529 account, so you can open one and let other people gift money to it. But leave your own huge contributions out until you’ve met or are making strides toward other goals.
What should be my first financial focus?
Daniela: So in short, if you have debt, that should be the first focus?
Erika Jensen: No, if you don’t have emergency savings that should be the first focus. Without emergency savings, you’ll end up in debt. If you pay off debt and don’t have emergency savings, you’ll end up in debt again. Think about it like this: if you have 7k in debt on 4 credit cards and you successfully pay it down to 1k, you can see the light at the end of the tunnel. But then, your air conditioner goes out. You don’t have emergency savings. What happens? You have debt again. Savings is priority one, debt two, making sure you’re getting at least your company match or making some contribution toward retirement in an account somewhere is three, and college is four.
Erika Jensen: “Savings is priority one, debt two, making sure you’re getting at least your company match or making some contribution toward retirement in an account somewhere is three, and college is four.”
What is a 529 and how does it work?
Daniela: Let’s say John & Mary are in a good financial shape and they are looking into the 529 option, how does it work? What do they need to do?
Erika Jensen: 529s are generally available state by state. if John and Mary live in a state with state income tax they should consider their own state’s 529 because it may be beneficial. In a state like Texas, they could really use a 529 from any state. Many are available online and set up is easy. Generally, 529s offer investment options that are mutual funds or exchange-traded funds; and, for people who don’t know how to evaluate investments, many have age-based investment options. These behave like target-date funds in retirement accounts. The age-based funds are more aggressively allocated for a newborn, then as the child gets older and nears college age, the allocation becomes more conservative.
Daniela: With regards to the 529, at which point can parents start using this?
Erika Jensen: It’s a great idea to have one for a newborn. My son was the first grandchild on my side of the family. So our house looked like I’d had octuplets. There were so many gifts. I didn’t open a 529 until he was almost 2 years old. A college savings account can actually be established prior to the baby’s birth. I wish I had done that. Let’s say John and Mary decided to start one prior to their baby’s birth. They’d start it using one of themselves as the beneficiary. There must be a social security number attached. Then, once the baby has a social security number, there’s a one-page form that’s used to change the beneficiary to the baby and there’s no cost or penalty to making the change. Some 529s will even give you postage paid envelopes for mailing in checks. Get those and give them to everyone in the family! It would be a cute idea to hand out envelopes and have everyone who contributes sign a card, then hold on to it until the baby is an 18-year-old heading off to school.
Erika Jensen: “Some 529s will even give you postage paid envelopes for mailing in checks. Get those and give them to everyone in the family! It would be a cute idea to hand out envelopes and have everyone who contributes sign a card, then hold on to it until the baby is an 18-year-old heading off to school.”
Daniela: That does sound like a good idea; a question related to the mechanics of the 529 – so the contribution the parents have to put in becomes less as the child grows?
Erika Jensen: Definitely not. The parents should contribute what they can afford and based on some goal. There are calculators online that will estimate college costs for private schools and public schools, in state and out of state. Many 529 websites have a calculator available. It will help parents determine how much they need to contribute to reaching a goal. If the parents can’t afford to fully fund college, then they can use the calculator to get a rough estimate of how much they are likely to fund at their current contribution rate. The earlier they start saving the better, the later they start the more they’re going to need to contribute.
Daniela: To make sure I understand correctly is the 529 specifically a college fund or a standard saving fund?
Erika Jensen: It is specifically for college. It behaves like a Roth IRA, but for education savings. The contributions are after tax. So, if they come out for expenses specifically related to school: tuition, dorms, books, etc. the money grows tax-deferred and comes out tax-free. irs.gov has a fact sheet on contributions and uses. If there’s money left in one it can always be transferred to another child. It can also be used for certifications and technical degrees as long as those are recognized by the US Department of Education. Some are even international.
Erika Jensen: A general savings vehicle such as Custodial Savings or Investment Account for a minor, a UGMA, or a UTMA can be used for any expenses, such as a first car. However, they don’t have the benefit of tax deferral and if there’s anything remaining in them when the child goes to college, that can count towards a higher percentage of the expected family contribution when applying for financial aid. That’s important for families who are at income levels where they’ll be counting on financial aid.
Daniela: Thanks for that overview. You said earlier that parents can use a 529 from any state, how would this affect college-choice?
Erika Jensen: From a Federal income tax standpoint, contributions are after tax. However, some states permit a state income tax deduction when contributions are made. The state where the 529 was set up should not affect college choice, as it generally only has to do with contributions. 529s can also be exchanged if the family moves to a state where they would like to take advantage of deductions. The only factor I can think of that might impact school choice would be the expense of paying out of state vs. in-state tuition.
Daniela: Very good to know, is there anything else related to 529s that parents should keep in mind before starting on such a plan?
Erika Jensen: Investment costs. If parents have the option to choose among multiple plans and they aren’t benefiting from savings on state tax deductions, then their biggest concern should be any custodial fees or expense ratios. Expense ratios should be disclosed and easy to find in a fact sheet on the 529’s website or in the prospectus. Expense ratios don’t show up on statements. What you see in performance reporting is performance net of a fee that’s collected by the investment management company operating the investments inside the account. Higher fees over an 18+ year investment time horizon can eat into valuable returns.
Erika Jensen: It’s also important to recognize that the investments in all 529 plans are reviewed for suitability. But, they’re still investments. An aggressive investment allocation, which is appropriate for a newborn is going to be close to 100% stocks. So, there will be fluctuations in account value. These are normal, and investing over the long term is a marathon.
Erika Jensen: In the global financial crisis, investors saw investment declines of more than 50% if they were invested in the S&P 500 from the top in 2007 to the bottom in 2009. Those that actually lost money, sold their investments. If investors didn’t sell then they doubled their money as of September 2017. That’s ten years, an average of 7.2%. It’s important for people using 529s to keep in mind that it’s long-term.
Daniela: Great, thanks for this insight. As a final take-home note, what would be that one piece of advice that you’d give expectant parents related to budgeting and their child’s college fund?
Erika Jensen: Remember that income – expenses = 0 for a balanced budget. A cash flow positive budget means there’s some left over for savings. If income – expenses = a negative number, income – expenses < 0, then the family needs to either increase their income or reduce expenses. Also, with regard to the 529s, there are some really excellent benefits related to the gift tax. It’s important to consult a tax advisor on this, but based on IRS publications, contributors can add up to five years of gift tax exclusions at one time. That is, if the gift tax exclusion is 14k this year, one person could contribute up to 70k at one time, or for a married couple up to 140k. If you have family members looking to reduce the size of their taxable estate now, this can be a great method.
Daniela: That is indeed very informative and the way you have described it shows how imperative budgeting is for healthy financials. I wish to thank you for your time and for the information you have shared with our readers today as they embark on their own parenthood journey and all that it brings with it. This will definitely help many as they analyze the various costs involved.
Erika Jensen: Thank you! It was great speaking with you this morning.