With so many great college savings options being introduced in recent years, it's hard to imagine that so many people still make catastrophically bad investment choices. Yet, with as many off-the-wall ideas as you see thrown around in the internet chat rooms, it's clear that people are still being led astray.
Most poor planning seems to arise from people's desire to either outperform the more trusted investment choices or to try and find a "sure thing." Both of these ideas, while noble, usually end up doing just the opposite of what was intended. Parents who put their eggs in these unconventional "baskets" often find themselves short on funds when it comes time to cash in and begin paying tuition.
Even though the promises of safety and return may be great, you should think carefully before placing your child's college fund in any of the following investments.
Life Insurance or Annuities
One of the most common missteps in setting up a college fund is the use of a life insurance contract as the underlying investment. Specifically, whole life and variable life insurance, as well as annuities, often get mis-selected as appropriate vehicles.
Oftentimes, insurance agents will encourage you to take advantage of the fact that life insurance or annuities allow for tax-deferred accumulation. Their theory is that if you bought the same mutual funds in a regular taxable account, you'd pay taxes every year on the growth. Thus, the insurance contract or annuity shields your growing college fund from Uncle Sam.
While this is partially correct, people who encourage the use of annuities fail to mention that you will still have to pay income tax on your gains when you withdraw the money, as well as a potential 10% penalty if you are under age 59 1/2. You may also face surrender charges if you withdraw money from an annuity early or cancel your life insurance policy.
They also fail to mention that you can get even better tax benefits in a Section 529 account or Coverdell ESA (Education IRA), with a 1% to 2% annual cost savings over an insurance or annuity contract.
Any time you reposition assets for a different purpose, it can increase your taxable income and expected family contribution, which can change your financial picture when it comes to paying for college.
Collectibles and Artwork
While the appreciation in value associated with artwork and collectibles can be significant, so can the downside. Unlike stock or bond investments, which represent a tangible claim on real financial assets, the value of art and collectibles is based solely on people's opinions.
The value of artwork and collectibles can change dramatically overnight solely because there are no more buyers for a certain type of item. Thus, they are extremely susceptible to things like fads, trends, and recessions.
While it might be fun to mix your appreciation of the finer things with the growth of your net worth, this should only represent a small portion of your overall portfolio, and none of your college savings.
Gold and Other Precious Metals
For a lot of people, gold represents the height of security and safety. It is real, tangible, and has been in demand for as long as mankind can remember.
Yet, that same tangible nature is exactly what can make precious metals a poor investment choice. The cost of acquiring and storing gold, especially in relatively small amounts, can quickly wipe out any appreciation in value. Additionally, keeping gold in your possession, even in a safe, potentially makes you a target for theft.
Considering the fact that gold has only earned 6-7% annually over the last 20 years, it seems to make this type of investment a lot more work than it is worth. If you really feel like you need some exposure to precious metals, consider buying a mutual fund that invests in established gold mining companies.
High Risk/High Return Stock Market Investments
Although the promise of a big payoff is tempting, consider steering clear of high-risk investments and strategies such as options, small companies, and international markets. The primary reason for this is that you will have very little time to make up for investment mistakes as the start of college nears.
In particular, you should avoid any type of investment where your "downside" is the potential for a total loss. This is the case with many types of options such as uncovered puts and calls, as well as investments in small companies in unstable third-world economies.
Though your 401K is a great investment vehicle for retirement, and even contains investment options worthy of your college fund, you should avoid viewing it as a source of college assets. Even though the underlying investments may be acceptable, the cost and timing of accessing the money could be disastrous for your broader financial picture.
For most people, their children will be going to college within 10-20 years of their expected retirement. Taking a significant distribution from what is most people's main retirement asset can put them back at square one with little time to catch up. Even taking a loan against your 401k's value generally freezes the growth of the underlying assets until the loan is paid off.
Even worse than a loan, is the idea of taking an actual distribution from your 401k to pay for college expenses. In doing so, you will pay federal and state income taxes on the withdrawal, as well as a 10% penalty if you are under 59½. This could easily cut a $10,000 distribution down to $5,000 or less.
In recent years, the government has encouraged parents to save for college with the creation of some very attractive investment accounts such as Section 529 plans and Coverdell ESA's. In addition to the attractive tax benefits associated with these accounts, you can choose from a wide array of investments ranging from guaranteed CDs to aggressive growth.
Before you look elsewhere, give these options a good look. They should be more than sufficient to meet future college costs when combined with regular savings.