My husband and I are both 46 and have a combined annual income of $70,000. We have one son, 15, whom we expect will attend a state university three years from now. College expenses will run about $15,000 annually. We own a house with a market value around $225,000. There is a $100,000 first mortgage at 7 1/2 % with twenty years remaining and a $20,000 home equity loan at 8% with six years remaining. The combined loan payments are about $1,100/month. We have no other loans or credit bills.
Our son has about $10,000 in savings bonds for school but we've followed previous advice given from other sources and saved for our own retirement over his college.
Could you review our IRA asset allocation and secondly (and more importantly), suggest steps to take over the next few years to pay for our son's college education? I've been thinking of putting more money into bonds. Also, should we put retirement savings on hold and pay off the home equity loan, so that we can possibly take out another one to help pay for college?
Your portfolio problems are minor compared with the problems you are creating by changing the priority of your financial goals. The good news is that you can help your son finance his college expenses without stopping your contributions to the retirement accounts. The bad news is that you'll be doing it by taking on additional debt.
Let's look at the portfolio first. You've got four big mutual funds investing in the same part of the stock market. The
Vanguard 500 Index is an index fund investing in
Fidelity Growth Company holds large growth stocks, not indexed, and
Fidelity Growth & Income is buying large growth and income stocks.
Vanguard Health Care is a specialty fund but most of its holdings are also in the large-cap area. All told, about half of your money is invested in large-capitalization stocks. That's OK as a percentage, but you should look at how those investments go together.
For example, your investment in the health care fund when combined with the health care investments in the rest of your mutual funds makes you overweighted in that sector of the market. Adding a health care emphasis to your portfolio is fine, but investing 18 1/2% of your portfolio in this one fund is too much.
If you look at the other three funds, the Vanguard Index 500 will approximately match the performance of the S&P 500, while Fidelity's Growth Company and Growth & Income funds are counting on their fund managers outperforming the S&P 500. One mutual fund is looking to outperform the index by investing in growth stocks and the other by choosing between growth or income stocks. There's bound to be overlap and I think you're better off with the Growth & Income fund than the Growth Company fund.
According to Morningstar data your current holdings are 15% in cash, 10% in bonds and about 75% in stocks. The cash percentage includes cash held by your mutual funds, which is about 4% of your portfolio. That percentage fluctuates as the fund managers buy other investments. The $12,000 you have on hand in your money market fund should be adequate as a liquid reserve. That means that if you want to add to your bond portfolio it should come from selling stocks or stock funds. Reducing your investment in the Fidelity Growth Company Fund and/or the Vanguard Health Care Fund to increase the bond investment to 15%-20% of the total portfolio will reduce your portfolio's risk, but also lower its expected return.
The Vanguard Short-Term Bond Index is a good place for your current holdings, but I wouldn't recommend adding another 10% of your portfolio into that fund. Even though it's possible to be long and wrong when investing in intermediate or long-term bond funds, consider investing in the
Vanguard Total Bond Market Index.
Saving for College
You've put retirement savings first and now your first priority is college expenses. I can understand why you're getting nervous. With his freshman year just three years away, the $10,000 you have earmarked for your son's education isn't even going to get him through that first year. That said, you did the right thing by prioritizing your financial goals and putting your retirement investments first. The reason that investing for retirement should come first is that you have a multitude of options in paying for your son's college education, but postponing retirement savings will leave you with few options in retirement.
Sit down as a family and work on a college budget. The "What will it take to save for a college education?" worksheet under the Savings header in
calculators section is a good place to start. Let your son know what he can expect from you financially and what you expect of him. Consider such questions as what happens if he takes five years to complete his four-year degree, and are you willing to finance all or part of a graduate degree?
After you put together the college budget, you'll have a much better sense of the money you'll need over the next seven years. Review your household budget to see if there is money available for contributions to the college fund, since what you can't accumulate from income you'll be looking to finance through either student loans or mortgage loans.
I'd advise against putting the retirement savings on hold to pay down your existing home equity loan. You've got plenty of equity in your home that you can use to finance college expenses later if that's how you decide to handle it. Depending on where interest rates are, it could make sense to do a cash-out refinancing of your first mortgage or just take out another home equity loan.
You could do a cash-out refinancing/debt consolidation now and deposit the college money in a
Section 529 College Savings Plan. The new tax bill makes qualified distributions from these plans free of federal income taxes in 2002 and beyond. Unfortunately, the conservative investment choices appropriate for such a short investment horizon limit the usefulness of this approach.
You can also tap your IRA to pay college expenses. You'll owe income taxes on the distributions but not the 10% penalty. But I'd rather see you borrow against your home than drain your retirement account. Letting this money continue to grow tax-free is an important part of meeting your financial goals in retirement.
Finally, you need to review your ownership of the Savings Bonds to see if you can realize any tax savings through the Education Bond Program. Savings Bonds purchased after Jan. 1, 1990 may qualify for the program, which allows taxpayers to exclude from their gross income all or part of the interest earned on an eligible Series EE or Series I Savings Bond. The condition is that the taxpayer, spouse or dependent has to have incurred qualified educational expenses at least equal to the principal and interest income from the redeemed bonds.
Importantly, though, the bonds have to be registered in the parent's name and have been purchased with your money, not the child's. If the bonds were improperly registered in your child's name, you can request that they be reissued to qualify for the program. If the bonds are in your child's name and he or she has been filing an annual income tax return to declare the accrued interest, then you've already minimized the tax obligation and shouldn't need to have the bonds reissued. See the
Bureau of Public Debt Web site for additional information on this program.
Dr. Don Taylor has been an investment professional for nearly 15 years, most recently as the treasurer for a nonprofit organization where he managed more than $300 million in assets. He is a chartered financial analyst, holds a Ph.D. in finance and has taught investment and personal finance courses at the University of Wisconsin and at Florida Atlantic University. Dr. Don's Portfolio Rx aims to provide general investing information. Under no circumstances does the information in this column represent a recommendation to buy or sell. Dr. Don welcomes your inquiries and feedback at