I recently ran across a post on ING’s We the Savers blog in which the author explains his plans to save for his kids’ education:
“What do I do for my kids? Play Russian Roulette with the market and pray there’s enough for them to pay for books?
I’ve got a better idea. I figured that if I start saving $50 a paycheck for them in an Orange Savings account, they’ll have almost $50,000 to do whatever they want to with when they turn 18. Not too shabby.”
He’s saving for his kids’ education, and he’s getting started while they’re young (they’re 3 and almost 1). So thumbs up to him for that. But his specific saving plan leaves something to be desired:
- It neglects to take advantage of any of the types of tax-advantaged accounts that would provide better tax treatment than a taxable savings account.
- It uses a short-term investment (cash) for long-term needs (college 15 or 17 years from now).
Tax-Advantaged College Savings Accounts
There are 3 primary types of accounts that could be used to save for college in a tax-advantaged way: 529 plans, Coverdell accounts, and Roth IRAs. They each have their pros and cons (discussed more thoroughly in the article I just linked to), but any of the three is likely to come out ahead of a taxable account.
Everything in a Savings Account?
In the quote above, the author clearly indicates that he’s uncomfortable taking on stock market risk. Fortunately, there are ways to earn higher returns than a savings account without having to take on such risk. In fact, if college is 15 years away, there’s a way to earn returns that are both higher and more predictable.
Specifically: Buy Treasury Inflation-Protected Securities (TIPS).
Because they’re not as liquid and because they experience short-term fluctuations in price, TIPS generally offer higher returns than savings accounts. For instance:
- If you were to purchase a TIPS maturing in January of 2025 (i.e., shortly before a child who is currently 3 would be going to college), you would get a 1.968% after-inflation yield.
- In contrast, an ING savings account is currently only paying 1.1%, and that’s before accounting for inflation.
Not only can TIPS offer a higher return, but their returns are more predictable. Savings account returns are not predictable over long periods because:
- Savings yields can change at any time, and
- Inflation isn’t predictable (that is, even if you did know you’d get an X% yield over the period, there’s no way to know what the real, inflation-adjusted return would be).
In contrast, if you purchase TIPS with the appropriate maturity, you can achieve a (mostly) predictable inflation-adjusted return.