Approximately seven in ten Americans report that money is a significant source of stress (71 percent), according to the American Psychological Association. That is why I’m launching my Financial Health Series with Shawn Perkins, a personal financial advisor.
Chronic stress has been shown to cause chronic disease and wreaks havoc with your psychological and physical health. One of The Simple Life focuses on nutrition and exercise, but is primarily about pursuing a truly healthy and happy life. Financial stress affects all of us at some point, so this is a great series to get your finances in order, which will ultimately lessen your stress, and make you a healthier person inside and out.
Gary Collins: Hi. This is Gary Collins, best selling author and creator of www.thesimplelifenow.com, and I’m here again with Shawn Perkins, with Principal Financial Shield. I did say that right, didn’t I?
Shawn Perkins: Principal Shield Financial.
Gary: There we go. I thought I had it out of order. What we’re going to talk about today is, again, continuing on with the five ways you lose money and saving for your kids’ education. Shawn, if you could elaborate on that.
I know it’s an important topic to people, because everyone, usually, starts putting away for their child’s education pretty early these days, because college costs you a small fortune anymore.
Shawn: It can. The inflation rate for college education is about double what the actual inflation rate is for the everyday things that you and I buy and pay for. It’s going up pretty rapidly and can be quite a shock when you start looking into it. I have a 24‑year‑old son that has already graduated college.
I can only imagine what the expense is going to be when my current 12‑year‑old daughter becomes 18 and wants to go to college. It’ll be a lot different. That having been said, the first that people look at is the vehicles that are available for, say, college.
That’s going to be your education savings account, what’s called your Coverdell education savings plans, and your 529 plans, which there are generally a 529 plan for just about every state out there. They have their own version of them. They vary slightly, but they all work on the same premise.
Then, you have prepaid tuition plans is another one. That’s basically you can pay for today’s cost of tuition. You give it to the school in hopes that that’s the school your child’s going to go to, and you can get today’s rates in the future. There’s some risk involved with that, but that’s not necessarily what this call is about.
With the 529 plans, with the Coverdell education plans, there are strings attached, as always. You have the ability to contribute after‑tax dollars to these accounts. The earnings or growth will grow tax‑deferred.
Then, if you pull the money out of those accounts for what the government refers to as “Qualified education expenses,” then you don’t have any tax due on the money that was contributed or the growth. You can just simply use it for paying for your kids’ education. The strings that are attached are many and varied. The Coverdell education plan limits you to $2,000 per year, per child.
You can only contribute up to that child’s 18th birthday. You better start saving early if you’re going to have enough to send them to college. The other limitation would be [inaudible 02:46] some of them, and the Coverdell education is you have income limitations. If you make over a certain amount of money, you can’t contribute to one at all.
That can be a little crippling, that you can’t save for your kids’ college education in that way because you make too much money. Another thing that comes into play would be the monies that you save in these types of plans are counted in a calculation on the FAFSA…Have you ever heard of a FAFSA worksheet?
Gary: I’ve heard of it.
Shawn: It’s a free application for financial student aid. It’s a form that basically everybody who has a child going to college, it’s almost a given you have to fill this out. That form determines how much access you have to financial aid, student aid for education. All of the monies that you save in these kinds of education plans, they go into the formula that calculates the family’s expected financial contribution.
If you have too much money in those accounts, they automatically disqualify you from any kind of financial aid. A lot of parents will think, “Yeah, but my student’s going to pay for it, or my kid’s going to pay for it, so it doesn’t matter. My income, my savings doesn’t matter.” It does matter.
They take into consideration what the parents earn or make to determine how much financial aid that the student qualifies for. Ways that we lose money are contributing to these types of accounts can decrease the amount of financial you might have access to, because they’re counted in the family expected contribution.
When you look at other ways to pay for education, some people pay cash. In order to pay cash, you have to save that money. If you save it in just a savings, CD type of a vehicle, you’re earning a rate of return on that cash in whatever vehicle you’re saving it in. If you take that money out and pay cash for the education, you’re no longer earning the interest on that cash.
We call that opportunity cost. We’re giving up the ability to earn interest on our money to pay for this education expense. You may not have any other options, but that’s one way. Another way that people do it ‑‑ and this one can be quite perplexing, let’s put it that way ‑‑ people accelerate the pay‑down of their mortgage.
They send extra money every month to pay their mortgage off as quick as possible, which while they’re doing it is reducing and or eliminating the tax deductibility of that mortgage interest, only so that when they get done paying off the mortgage, they turn around and refinance and borrow the money back to pay for the college education.
Gary: I’ve seen that. I’ve seen that many times.
Shawn: When they do that, they are killing their tax deduction in more ways than one. One way is they’re killing their tax deduction because each payment that they make, they’re reducing the principal balance, which reduces the interest that they pay, which raises their taxes.
But the other side of that is there’s something called acquisition indebtedness, which is the initial debt you take out when you buy your home, that first mortgage amount. As you pay down the balance of your mortgage, that acquisition indebtedness reduces. When you pay the mortgage off in full, you no longer have the ability to deduct any interest on that house as acquisition indebtedness.
You only now have an additional $100,000 worth of home equity indebtedness that you can write interest off on. You may or may not be able to deduct the interest when you pull that money back out to pay for education. It depends on what you’ve done, with regards to refinancing your home over the years that you’ve had it.
That’s a deeper conversation, so I just wanted to touch on that.
Gary: That’s where you need an expert, when you get into that stuff. That sounds pretty complicated, right there.
Shawn: It is a little. There’s a lot of moving parts. Let’s put it that way. One of the things I wanted to point out, and this can be a biggie, regarding the 529 plans or the Coverdell education savings, which is an education [inaudible 06:40] , basically, is the possible tax law changes. This could be a biggie. The last several administrations have proposed in their budgets to begin taxing 529 plans.
Whereas you could put in, up today, you can put in after‑tax dollars, and you can defer the tax on the growth or the earnings of that, and then pull the money out, tax‑free, to pay for education. The last several administrations have proposed changing that such that you have to pay tax on the earnings and the growth on those accounts.
What they would typically do, though, is grandfather in any money that you currently have invested in those accounts, so that you don’t have to pay tax on that, but you’d have to pay tax on any future contributions. Now it becomes an accounting nightmare because it’s hard to segregate which was before and which was after the tax law changes.
If they suddenly make those accounts taxable, that means you now have to save even more money to be able to pay the tax and have enough left for your child to pay for college. That’s something that can change. Tax law changes are on a whim. They just, “We need more money. Here’s one way to get it.”
Another thing to consider would be any money that you save for your kids to go to college is money you’re not currently saving for either your emergency reserve or for your own retirement. That doesn’t mean that you don’t do it. It just means that you’re interrupting compounding, as I call it.
Many of us know what compound interest is. It’s when your interest is earning interest. If you have $1,000 in an account, and it’s earning five percent, then at the end of that year, you’d get $50 in interest. Next year, $1,050 is going to earn that five percent and so on.
If you build that account value up to $20,000 or $30,000, and then you withdraw that money to pay for college, you’ve interrupted the compounding of that money. Each one of us only has one compounding cycle in our lifetime. That means that from the day that you begin working, say at 18, you have until you go to retire to grow your money, to grow your wealth.
If we save money, it grows, and then we pull the money out, and then we save money, and it grows, and pull the money out, we are resetting the compounding curve every time we do that. The biggest part of our compounding curve is in the last five or so five years of that money growing, uninterrupted. Every time we interrupt compounding, we reset that curve.
Again, that might be a more complex thing. Let me give you an example. Take a penny a day and double it for 30 days. What do you think that’s going to grow to?
Gary: [laughs] Don’t test my math skills out.
Shawn: You don’t have to answer it, but I want the concept. Day one, you have a penny. Day two, you have two pennies. Three, you have four. 8, 16, and so on. By the time you get to day 21, you still only about 50 bucks. But by the time you get to day 30, you have $5.3 million. In that last few days of that 30‑day curve, and make that a 30‑day curve or a 30‑year curve.
In the last few days or the last few years is when the maximum amount of growth happens. When we reset that curve, we’re giving up that true compounding that we’re shooting for. Here’s another example I’ll use in that. This one, you would relate to. Let’s say you’re going to run a 10K. You start out the race, you’re thinking, “I’m OK. I’m just fine.”
About a mile or two into it, you start to realize that, “I’m a little thirsty.” All the water’s on a table, back at the starting line. You have to turn around and go back to the starting line to get your water. If you do that, what is the chance that you’re going to finish the race?
Shawn: Still good, right? What’s the chance you’re going to get back to where you were before you came back to get the water?
Shawn: You’re not going to get there. You’ve lost that time, and you have to keep running, and you can’t make it up. That’s the example of resetting compounding. Those are the biggies, right there, of how you lose money in saving for college is changing tax laws, resetting compounding, trying to accomplish too many goals at the same, so you don’t make very much headway on any one of them.
The mortgage is a big one, because that’s where most people go to get the money to pay for college.
Gary: That’s the one I’ve seen most commonly, recently, is people taking out the equity line in order to pay for their kids’ college at a high‑end school. That never sounded like a good idea to me, no matter what, but my attitude is I’m a little simpleton. If you can’t afford the higher, expensive school, there’s plenty of lower‑end state schools that will educate you just fine.
People get wrapped around that. There’s obviously these income curves in all the magazines that you see and all that. It’s true. If you go to Harvard, the odds of you coming out further ahead of someone going to Cal State Bakersfield is much higher, but it’s also you were born on third base, more than likely, so you hit a home run.
It’s a little different. That’s why I always look at those numbers as skewed, as opposed to the kid who went to Cal State Bakersfield, who probably started life in the batter’s box, like the rest of us. It’s a little hard to equate that. I don’t think going $100,000 in debt under any situation to go to school is a wise idea. That’s what’s happening.
Most students, it’s 50 to 100 grand, they’re going in the hole. It doesn’t make sense. Then their parents, if they don’t pay for it, the kids take student loans. To me, it’s just figure out the best way to pay for it and not have a lot of debt.
Shawn: I work with a lot of people that I see in their late 30s and early 40s that are still paying for the student loans from when they went to college. It can be quite staggering. They have very favorable interest rates, usually three to four percent, those loans are largely gone today. Now, a lot of times you have to get, coincidentally, Perkins loans is what they call them.
You have to get student loans that are now running in that 79 percent range. Even though the interest on student loans is tax deductible, it’s just not enough to offset that increased cost. One other thing I’ll throw out there is that the illiquidity of these types of accounts. Being able to access this money, it’s not very accessible.
If you take it out, you’re going to have to pay the tax on it. It’s subject to your ordinary income tax rates. What many people will do to avoid that, if they need money quick, is they have to go to credit sources to get money. Now, there’s another opportunity cost.
To prevent yourself from accessing that education money to prevent yourself from paying those taxes, you now will go to get into debt with credit cards, which have much higher interest rates and things like that. It can cause problems from that standpoint, as well.
Gary: Education’s tricky. It was about seven percent. I took out Perkins loans when I was in college, but my tally was not high at all. I ended up with 4500 bucks, and it was just to get through my last year of college, just to make sure I could afford it and get through. Other than that, I paid that off in the first year after I got out.
People spend that within the first couple weeks of college now.
Shawn: We didn’t start out with this particular call here to say college is either good or bad. College is fantastic for a lot of people. My son went to college, and I assume my daughter will, as well. I’m not going to require them to, obviously. It’s totally up to them.
This is about how you pay for college and how it can really become an albatross around your neck, because it’s such a long‑term debt, but it is a good thing if you don’t waste your time in college.
If you get an education truly in the field that you anticipate working in, and you’re going to earn enough money to make the difference between not having that education in that field of college education and having an education, then it’s certainly worth it. I’m not going to discourage anybody. I’m doing that.
I’m trying to let people know that there are other ways to save for college that may not have these backlashes, these snap‑backs that they don’t know about and they won’t necessarily find out about until it might be too late.
Gary: Shawn, let everyone know where they can get in touch with you, if they need your services.
Shawn: My blog address is www.wiseandwealthyblog.com. My cell phone number is 619, area code, 994‑1110. My email address is [email protected], where principal is P‑R‑I‑N‑C‑I‑P‑A‑L. Lastly, my website is principalshield.com. Those are the four ways to reach me. I’d be happy to help anybody out in any way that I can.
Gary: Thanks a lot, Shawn. Everyone can get a hold of me at [email protected], if you have any questions, which I get some here and there, and it might spur some other episodes. Thanks a lot for coming on. I’ll talk to you later.
Shawn: You bet.
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