lanning for their son Matt’s education is one of Jim and Anne’s top goals.
They are not currently utilizing any specific strategies for accumulating funds; however, $22,000 of their municipal bonds were purchased with college in mind. Jim’s parents just informed him that they set up a 529 plan for Matt’s college education and plan on depositing $100 per month into the account until Matt goes to college. This got Jim and Anne thinking that they should perhaps be gaining some tax efficiency and that there may be a more strategic way of accumulating college funds. They wish to accumulate enough to cover
$20,000 of education costs for four years, adjusted for inflation at 4.5%. Part of that will come from the $100 per month from Jim’s parents and from the $22,000 they have already accumulated. They would like to know what they need to save in order to have the money accumulated prior to Matt attending college because they believe there may be additional expenses during his college years that will need to be paid from current income.
Projecting College Funding
Additionally, after discussing the relationship between normal inflation and college inflation, they realize that municipal bonds may not be the best answer.
They would like to understand the benefits and drawbacks of both Coverdell and 529 plans. For purposes of this course, we are going to assume that the
investments will achieve the same 5.5% after-tax return for both the
grandparents’ and parents’ contributions. In real life, you would hopefully be coordinating the investments of both plans and the assumptions.
Your first step is to calculate what they will need to accumulate at the start of his first year of college. The process of calculating this amount may be tested on the CFP® Certification Examination. Once the goal is determined, you will calculate what Jim and Anne would need to save to achieve this goal on a level funding basis. There is a chance that they need to delay saving for a year due to their many other goals. If this is the case, you will have to recalculate the answer based on reducing the time frame by one year. You may complete other
P
calculations such as using an increasing payment versus a level payment. The only requirements are:
1. You cannot change their goal, inflation, or interest rate assumptions.
2. There cannot be a negative cash flow in any year on their cash flow changes tracking sheet unless you have saved funds from the prior year to cover the shortage. This means no negative cash flow in the first year!
The first step is to project the amount that will be needed over the four years of college. Since the amount will continue increasing due to inflation during those years, you can’t simply assume that $20,000 x 4 projected forward is accurate so you need to calculate how both inflation and earnings will impact that amount.
You are bringing those numbers back to the BEGINNING of college. You will then calculate how much is needed to be saved to reach the goal at the END.
Thinking of problems in this way can help you determine when to use beginning and end mode.
Figure 9: Education Savings Calculation Illustration
Some of the calculations require an inflation-adjusted return. The formula for creating the inflation-adjusted return is as follows:
1 + interest rate
Inflation-adjusted return = -1 100
1 + inflation rate
×
For a shortcut method of doing this calculation on the 10BII+ calculator
(assuming a 4.5% inflation rate for education and a 5.5% investment return), use the following keystrokes:
1. Enter 1 plus the inflation rate (i.e., 1.045)
2. Press the INPUT key
3. Then enter 1 plus the interest rate (i.e., 1.055) 4. Press the [SHIFT] key
5. Then press the percent change key
6. Your answer should be on the calculator screen as 0.9569
See if you can complete the calculation on your own and then review the answers below. This will be a good test of whether you have mastered your calculator.
Table 17: College Funding Calculation
Step 1: Estimate amount needed at start of education goal to provide desired income stream. (Use “begin” mode)
Number of years to college: 18 - 5 = 13 years Number of years in school: 4 years
PV: (income goal) $20,000
N = years until college 13
I = education inflation 4.5%
? FV = first year required income $35,444
Step 2: Calculate lump sum needed at first year of college to provide increasing education costs.
PMT - first year required income $35,444
N = years of college being funded 4
FV = amount desired left at end 0
I = inflation adjusted return * 0.9569%
? PV = lump sum needed $139,773
Step 3: Calculate what current investments will be worth by first year of college and subtract from needed amount. (Use “end” mode)
PV = current allocated amount $22,000
PMT = any LEVEL payments (increasing payment is separate calculation) $1,200
I = portfolio rate 5.50%
N = number of years until college 13
? FV = accumulation at start of college $66,071 Subtract from target to identify new savings target $73,702
Step 4: Calculate level amount needed to achieve target.
PV = 0 $0
FV = target $73,702
I = portfolio rate 5.50%
N = number of years until college 13
? PMT $4,030
Plan Development #20
Now that you have the minimum dollar amount needed to save calculated above, you need to answer Jim and Anne’s questions concerning Coverdell and 529 plans.
Calculate the Colorado state tax deduction for the contribution to the 529 plan. Colorado provides an unlimited state tax deduction for contributions to 529 plans. With the state tax rate of 4.63%, what would their state tax savings be on the amount required to save? You may need to recalculate this later if you change the funding amount due to cash flow after you have completed your total analysis. It is helpful to utilize Excel to track your cash flow and enter a formula for tax savings versus a dollar amount.
(Note that different states have different rules for deductibility and contribution limits.)
Write a comparison between the Coverdell and 529 plans with bullet points highlighting the advantages and disadvantages of each plan. Be sure to include the consequences if their child does NOT spend the money for college. This will be part of your executive summary. Because of the drawbacks and potential penalties, you may choose to recommend that the funding be monitored at some point in the future so that there is no potential for overfunding the plans.
Another point to remember is that this calculation is assuming a level, consistent return, which we know is unrealistic. Monte Carlo analysis has
shown that savings typically need to be higher than this calculation, so this calculation becomes the MINIMUM amount needed if you want a shot at achieving the goal.
Write your recommendation for funding college through tax-advantaged vehicles. Be sure to be specific on the advantages and disadvantages of your strategy, including the tax consequences. Remember to add this to your cash flow changes page and include the tax savings if you are using part or all of the contribution into 529 plans.
You may make recommendations in the next section concerning retirement that will have tax consequences. Because you are writing your recommendations in the same order as you are developing them here, save the comments on the tax benefits and consequences of retirement plans for the retirement section. While tax benefits may be important components of your choice, they will be driven by the desire to accomplish the goal of creating a secure retirement rather than tax planning.