The Impact of Inflation on College Savings

When surveyed by The College Investor (TCI), 75% of parents with college-bound children said that they are currently saving for their child’s college education. TCI also found that over 80% of parents are concerned about the impact of inflation on college savings. The amount that parents need to save rises in line with college tuition, which has risen much faster than the general CPI rate of inflation since 1980.

The TCI findings also indicate that, although parents plan to save an average of 69% of their child’s anticipated college costs, they are actually on track to save only 27%. This is largely due to parent’s underestimation of the rate of tuition inflation.

IRS Section 529 Accounts

A 529 account, named for Section 529 of the IRS tax regulations, is a type of savings plan that helps people save for college and other forms of post-secondary education. 529’s offer significant tax benefits. Along with Education Savings Accounts, 529’s are the most popular tax-advantaged method of saving for college.

The characteristics of 529 accounts are outlined below:

• Contributions: Earnings on contributions grow tax-deferred.

• Withdrawals: Withdrawals for qualified education expenses are tax-free.

• Investment Options: 529 plans offer a variety of investment options, including securities such as stocks, bonds, mutual funds, and exchange-traded funds.

• Tax Benefits: 529 offer tax benefits in some states as well as on Federal taxes.

• Gift and Estate Planning: Contributions up to a certain amount are not subject to the Federal gift tax.

• Eligible Account Holders: Parents, guardians, and anyone else who wants to help fund a child’s education can open a 529 account for them.

• Beneficiary: The beneficiary is a minor child, which can be changed at any time.

• Use of Funds: Funds can pay for tuition, fees, books, equipment, or room and board. A portion of a 529 can be rolled over to a Roth IRA in the beneficiary’s name.

The Impact of Inflation on 529 Accounts

In setting up a 529, account holders should consider the significant impact that inflation can have on a 529 plan in the following ways:

1. Cost of Education: As the Consumer Price Index (CPI) rate of inflation rises, the cost of tuition typically increases at an even greater rate. This means that the amount saved in a 529 account may not keep pace with rising tuition unless the investment returns substantially outpace inflation.

2. Investment Returns: If the investments within the 529 do not yield returns significantly above the CPI rate of inflation, the real value (purchasing power) of college savings will diminish over time.

3. Contribution Strategy: Families may need to raise their contribution amount to account for anticipated higher tuition costs in the future.

4. Withdrawal Timing: Inflation can upset the timing plan under which families need to withdraw funds from a 529 account.

Inflation Projections and 529 Goals

Inflation projections play a large role in shaping 529 savings goals in the following ways:

1. Adjusting Savings Targets: If inflation is projected to rise, families need to increase their savings targets to ensure that the funds will be capable of covering future college tuition as planned.

2. Investment Strategy: Understanding inflation trends should guide investment choices within the 529 account. Families might opt for more aggressive investments if they anticipate high inflation, aiming for returns that keep pace with tuition inflation rates.

3. Real Value of Savings: Inflation erodes purchasing power. Projections help families assess how much their savings will be worth in real terms when it’s time to pay for college, prompting adjustments in either the amount of contributions or the investment strategy or both.

4. Withdrawal Planning: Knowing potential inflation rates helps families select optimal withdrawal times and amounts, ensuring that they have available funds throughout the duration of a college education.

5. Budgeting for Additional Costs: Beyond tuition, families should consider other rising costs associated with a college education (e.g., housing, books).

Inflation and the volatility of securities markets has less of an impact on 529’s if families who choose an Age-Based or Enrollment-Date asset allocation feature. These pre-planned investment strategies periodically adjust the mix of investments, reducing the percentage invested in equities as the child approaches college age. When college enrollment is near, the allocation for stocks may decline to 10% of the total amount in the account. This reduces the exposure of a 529 account to a major stock market decline when it’s too late to recover from it. Almost 70% of current 529’s use an asset allocation strategy.

Incorporating inflation projections into planning allows families to set realistic and achievable long-term savings goals for a 529. Reviewing inflation projections periodically can ensure that the savings strategy remains aligned with economic conditions.

Families Can Refer to a Reliable Inflation Projections

Families can research CPI inflation projections from a variety of reputable sources. They should consider several based on different perspectives to form a balanced view of the probability of future rates. To their estimation of future CPI rates, families should assume an even higher rate of tuition inflation. Among the sources of reliable inflation forecasts are the following:

1. Bureau of Labor Statistics (BLS): The BLS, as part of the Department of Labor, provides inflation statistics which include the CPI.
2. Federal Reserve: The Fed publishes economic forecasts and reports that include inflation projections.
3. Economic Research Institutions: Organizations such as the National Bureau of Economic Research (NBER) and national research universities conduct studies and publish reports on economic trends including inflation.
4. Financial News Outlets: Financial news organizations like Bloomberg, Reuters, and CNBC report on economic indicators and provide analysis on inflation expectations.
5. Investment Firms and Banks: Many investment firms and banks produce market outlooks that include inflation projections.
6. Academic Publications: Academic journals in economics often contain research articles discussing long-term inflation trends and projections.
7. Online Financial Tools: Websites like Trading Economics and MarketWatch offer tools to track historical and projected inflation rates.

Coping with Tuition Inflation:

Parents can mitigate the impact of tuition inflation by adopting some or all of the following practices:

1. Increase Contributions: Increase contributions to the 529 plan regularly; even small amounts help over time.

2. Investment Options: Choose appropriate investment options that align with risk tolerance and time horizon. Aggressive investing may be most appropriate for 529’s for young children. Age-based investment portfolios that automatically adjust as college approaches should be strongly considered.

3. Tax Benefits: Take advantage of tax-free growth and withdrawals for qualified education expenses. This helps planning for tax avoidance.

4. Scholarships and Grants: Research and apply for scholarships or grants to supplement savings and reduce college costs. Stay informed about financial aid opportunities available at colleges that can help offset rising costs.

5. Budgeting: Create a comprehensive budget that includes projected income and expenses and accommodates expected tuition increases.

6. State-Specific Plans: Investigate state-specific plans that may offer additional benefits or incentives, such as tax deductions on contributions. Some state plans are available to non-state residents.

7. Alternative Education Paths: Explore community colleges and online programs as low-cost alternatives for two years prior to transferring to a four-year institution.