Personal Finance

The best way to save for future college expenses is to put money in the most effective place to build wealth the fastest.  That often means maximizing our contributions to our 401(k) or IRA.  Money saved in a 401(k) or IRA can be used to pay for college and under current law does not reduce eligibility for financial aid.  The best way to pay for current college expenses is to take money from the most advantaged source that still allows your wealth to grow the fastest.  That may mean using government subsidized loans and tax credits, paying out of current income or pulling equity out of your home. 

In real life no one knows what methods for paying for college will be available years from now.  We have only to look at the recent changes to understand the challenges of financial planning for college in the future.  Twenty years ago Education IRA’s and state-run Section 529 plans did not exist.  Twenty years ago there were no provisions to borrow from your 401(k) plan or to make penalty free withdrawals from your IRA to pay for children’s college.  There were no education tax credits.  The concept of using home equity to pay for college was not an accepted practice.  Liquidation rules for US Savings bonds did not allow an exemption from federal and state taxes if the bonds were used for qualified college expenses.  Many of the federally subsidized loan programs were not available twenty years ago.  The reality is we do not know the best way to pay for college education even five years from now.  We do not even know for sure if our child will attend college.  Planning for college is an example of what we call “planning under extreme uncertainty”. 

Most of us should not be setting aside money for children’s college until we have adequately funded our own retirement.  The government and financial institutions will lend you money for education just as they will lend you money to buy a home.  But no one will lend you money to pay for your retirement. 

Paying for your children’s college is a great act of love.  But building your wealth so you can pay for long term care in your old age may be an even greater act of love.  The “sandwich generation” refers to the growing number of families who find themselves financially impacted by the need to care for children and aging parents at the same time.

The table below illustrates one more reason it is usually better to keep assets in parents’ name until the child receives an invoice for college expenses. 

Investors face many kinds of risks:

Exogneous Risks – Risks that are external and common to all investors
1. Market risk – Risk which is common to an entire class of assets
2. Interest rate risk – Risk that value will change due to a change in interest rates
3. Reinvestment risk – Risk that future proceeds will have to be reinvested at a lower interest rate
4. Business risk – Risk associated with the unique circumstances of a particular company
5. Liquidity risk – Risk that security cannot be sold quickly
6. Default risk – Risk that company or individual will not be able to meet contractual obligations.
7. Industry risk – Risk which is common to a specific industry
8. Deflation risk – Risk of contracting (vs inflating) volume of money and credit relative to available goods. Considered the most dangerous risk to an economy because consumers stop spending and hoard cash. This triggers a vicious cycle of increasing unemployment and declining economic activity which is difficult to reverse.
9. Inflation risk – Risk of expanding (vs. deflating) volume of money and credit relative to available goods. Also called “purchasing power risk”.
10. Uncompensated risk – Risk for which the investor receives little or no reward because the risk can be diversified away.

Endogenous Risks – Risks that are internal and specific to the individual investor
1. Longevity risk – Risk of outliving your money
2. Unemployment risk – Risk of no income
3. Morbidity risk – Risk of disability or need for long term care
4. Mortality risk – Risk of premature death
5. Cash flow risk – Risk of insufficient cash to meet living expenses
6. Default risk – Risk of not being able to meet contracted financial obligations
7. Decision making risk – risk of suboptimal decisions triggered by emotions, lack of knowledge, bad information or bad advice from media or incompetent advisors. Evidence suggests this is the greatest risk faced by investors.
8. Fraud risk – Risk of being defrauded by criminal activity of advisor (Madoff, etc.)

The three Commandments for Successful Investing
1. Thou shall not take any risk that thee dost not need to take
2. Thou shall not take any risk for which there is not commensurate reward
3. Thou shall not risk any money thee cannot afford to lose.