Paying for College Tax-Free
Dec 5th 2012 7:46AM
Planning for College used to be pretty easy. In Texas, there was the "Texas Tomorrow" fund, a dedicated fund that allowed parents to lock in prices at colleges around the state. One problem … that fund is closed. There are now various 529 plans, which allow tax-free growth of your investment and tax-free withdrawals on earnings used for qualified higher education expenses. These plans are run by large investment advisory firms on Wall St. and often have some warts. First, they are often burdened with typical high expense ratio mutual funds. Secondly, many of these plans invest in the stock market. If your four-year old is starting to college in 2026, and the stock market crashes like 2008 in 2025, you may be in big trouble.
But there is another avenue, the zero-coupon bond. A zero-coupon bond is an accrual instrument. They do not pay semiannual interest like a regular bond. They are priced at a discount to the par value (par value on bonds is $1000) and each year accrue, rather than pay interest. The downside to a U.S. Treasury zero-coupon bond is that even though you do not receive interest, the accrual interest is taxable. You can put them in a 529 plan and avoid taxation, but the problem with that is that U.S. Treasury rates are at historic lows. So what is the answer? Municipal zero-coupon bonds. These are debt obligations of municipal, county and state governments. They also accrue interest tax-free and have higher yields than U.S. Treasury bonds.
Is there risk in muni bonds? Absolutely, the city of Stockton, Calif., declared itself bankrupt last summer. The solution, find bonds from areas with thriving economies and a low risk of default, like Texas. Or purchase bonds that are insured.
Here is how a municipal zero-coupon college portfolio might look for parents with a four-year-old child today. Assume that they start college in the fall of 2026. Assume you have to account for tuition, room and board and expenses. Lastly, also assume a state college for an in-state student. Clearly if the child attends Harvard or Stanford, or attends an out-of-state college, the costs will be higher.
In the 2011-2012 school year, the in-state tuition at Texas A&M in College Station Texas was $8,419. For 2026 you tack on an additional 20% cost increase to account for rising tuition costs. So that raises the cost to $10,100. Add an additional $5,000 for room and board plus expenses, even if the student resides in a dorm the first two years. You need approximately $60,000 over the four-year span.
We found several offerings that would make due for a laddered portfolio of munis that were all rated AA or better. And all matured from 2025 to 2029. These were real issues up for offer this week and included issuers like Houston Texas Water and Sewer, Beverly Hills California Material Events, Crowley Texas ISD PSF Guaranteed and Long Island Power Authority. The tax-free yields on some of these were more than 3%, so if you are about to get a jump in your tax rates, then these look far better on a taxable-equivalent yield basis.
For approximately $40,000 you can fully fund a four-year college tuition today with a four-year municipal bond laddered portfolio, and pay no tax on that income along the way. If you do not have all of the funds at once, you buy the maturities as you can, purchasing the earliest maturing bonds first, as they will be the most expensive.
If you do not need to be planning for college but have another planned expense that you cannot save for in a tax-free account, this strategy of a laddered zero-coupon muni bond portfolio will work for that too. There is a reason that municipal bonds and their tax-free status with the IRS are in such high demand by the wealthiest families in America.
Lee W. Jackson
Filed under: 24/7 Wall St. Wire, Bonds, Dividends & Buybacks, Personal Finance