Hypothetical Henry: Compounding His Way to College

Parents and/or grandparents can build wealth for their kid or grandkid by investing money at the youngster’s birth or early in his/her life.

As I often preach, wealth is created by saving and investing over long periods of time. For a youngster to get the biggest bang for the buck – and because most of them have little or no disposable cash – parents and/or grandparents can build wealth for their kid or grandkid by investing money at the youngster’s birth or early in his/her life.

Hypothetical Henry’s situation offers an example of planning ahead.

You’ve heard the numbers, $1.5 trillion of mounting debt and counting. And the stories that Millennials are so bogged down in student loan debt that many of them postpone marriage, home buying, family creation, etc. Henry is a Gen-Zer and thank goodness for that – unless he follows in the footsteps of so many of those Millennials and older Gen-Zers. There’s a glimmer of hope for Henry. He’s only 13. He still has five years to plan for college if he chooses to go. Wait a minute… 13 years old… isn’t it a little late in the game to start making plans to finance a college education? I agree, it is a bit late, but I firmly believe in the saying: It’s Never Too Late, But Early is Best!

Henry’s case is a hypothetical situation presented to demonstrate what can happen if planning for the college “financial” experience is addressed early on. And because it is hypothetical, let’s begin with the usual theory that Henry was very careful in choosing his parents.

For starters, Henry’s parents opened a 529 Qualified Tuition Program shortly after his birth. 529 Plans are operated by state or educational institution with certain tax and other advantages to ease the burden of saving for college and other post-secondary training. Likewise, they can be used to pay for tuition at elementary or secondary public, private, or religious schools for the designated beneficiary. Earnings are not subject to federal tax and typically not subject to state tax when used for the qualified education expenses such as tuition, fees, books, as well as room and board at eligible education institutions and tuition at elementary or secondary schools. Note: Although contributions to 529 Plans are not deductible, they offer tax-deferred growth and tax-free withdrawals. You won't pay any income taxes on the amount your account earns while it's growing, and if you use the money for qualified education expenses, those earnings will be tax-free when you withdraw them.

They immediately started depositing $2,000 per year in the plan, invested every penny in an unmanaged Total Stock Market Index Fund…and as [bad] luck would have it, during the plan’s third year, the Great Recession reared its ugly head (every story needs a bit of drama). The plan’s excellent first year return,15.63%, looked fantastic when compared to year two, 5.57%, then – ouch! – here came year three…the Great Recession… a (negative) -36.99%. But Henry’s parents were true believers in index fund investing for the long haul. They stood strong, and the next two years rewarded them with double digit returns of 28.83% and 17.26%, respectively. Henry’s 529 Plan was back in business. And over the next eight years, it enjoyed five years of double digit returns, two years of – argh! – less than 1%, and only one more of those negative years, down 5.17% in 2018.

Hypothetical Henry’s 529 Plan experienced on the front-end, the Great Recession, and has since enjoyed several years of an extended bull market – a mixture of more good times than bad. He also enjoyed a mom and dad who faithfully employed the PDQ Principles of investing: Patience… Diversification… Quality. Reminds me of that conservative old gentleman, Benjamin Graham, who said, “The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a simple financial plan and are exercising a behavioral discipline that is likely to get you where you want to go.” We’ll discuss those PDQ Principles of investing at length in future blogs.

Before we get back to Henry, though, if a parental plan is to minimize college debt, a big first step might be to have a college-bound youngster attend, if circumstances permit, a local junior college to enjoy cheaper tuition and fees and “free” room and board – while taking core curriculum courses. But that’s another topic. The 529 Plan Henry’s parents created years ago, barring a market meltdown, will probably enable him to attend a large state institution away from home.

Let’s review Henry’s situation with some facts. In doing so, let me introduce you to a wonderful program called the College Savings Planner that helps parents determine whether or not they are on course to meet financial goals. Developed by Vanguard, it’s user friendly and among other things, provides general information about the cost of attending various institutions around the country.

In Henry’s case, after investing $2,000 per year for 13 years, earning approximately 9.25% per annum, his plan currently holds $52,265 despite the slow start. His parents plan to continue investing $2,000 per year but because the current bull market is getting long in the tooth, they decide to adopt a more conservative 6.2% annual yield outlook until Henry graduates – not the 9.25% they’ve enjoyed so far (despite the Great Recession).

Based on the current plan balance and assuming an annual college expense of $28,400 (tuition, books, room & board, etc., plus a 5% inflation factor), they currently have about 2.5 years (60%) of Henry’s education covered. To get to 100%, they would have to contribute an additional $5,800 per year, assuming a 6.2% annual yield. By the way, if their index fund continued to yield 9.25%, they would only have to contribute $3,500 per annum to reach 100% coverage. Vanguard also has good information on 529 plans.

In summary, Hypothetical Henry is in good shape financially because his parents started planning for his college experience very early in his life. Consider the alternative of doing nothing or starting too late in the game to avoid those crushing student loans. Perhaps this information about 529 plans and the Vanguard planning tool will help you avoid membership in the $1.5 trillion student debt club. And remember my mantra about getting started: It’s Never Too late, But Early is Best.