More Straight Talk on Investing. John J. Brennan

      Baseline Basics: Accounts for Saving for College

      There are a variety of ways to save for college, and the investment vehicle that's best for friends or relatives may not be the best one for you. The trade-offs involve costs, taxes, financial control, investment choices, and the impact that the plans have on eligibility for financial aid. Here is a brief look at the three popular ways to save for college.

       529 College Savings Plans are a tax-advantaged means of accumulating money to pay for college or graduate school. These plans, named for a section of the tax code, are usually sponsored by states and have emerged as the go-to accounts for many Americans. The earnings of 529 accounts are exempt from federal income and capital gains taxes so long as the money goes for qualified school expenses. You are not relegated to investing with the plan in your home state, and some states offer deductions on contributions. And there are no income limits to be eligible to use the plans. 529 plans may also be used to pay up to $10,000 in student loans. The main drawbacks of 529 plans are the overwhelming number of choices both among state plans and investment options in those plans and, in some cases, high costs of those options. The sponsoring state selects the investment manager and investment options available to you. In addition, some 529 plans layer administrative fees on top of the fees charged by the underlying mutual funds. Before investing, do some comparison shopping. The effect of 529 College Savings Plan assets on eligibility for financial aid depends on who is the named owner on the account. A 529 account held in a parent's name will cut into financial aid eligibility far less than will an account held in the student's name.

       Education Savings Accounts (ESAs; formerly known as Education IRAs) are another, but less commonly used, tax-exempt investment vehicle. You can contribute up to $2,000 a year on behalf of a beneficiary under age 18, assuming that you do not exceed income limits. The funds can be withdrawn tax free to pay for qualified educational expenses at primary schools, secondary schools, colleges, and universities. Another plus: You may choose the financial provider and the investments for your ESA, so you'll have a wide array of investment options from which to choose and can seek out low-cost options. With ESAs, the main drawback is the low maximum contribution. An ESA account alone may not enable you to save enough to cover four years of college. In addition, assets in an ESA count heavily against a child's eligibility for financial aid. In financial aid calculations, ESA assets are considered to be the student's property. As a result, financial aid providers will expect that up to 25% (for college aid) or 35% (for federal aid) of the ESA will be spent for college each year.

       UGMA and UTMA Accounts are custodial accounts for children established under the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act (hence the acronyms). These accounts have been around for decades. With an UGMA/UTMA, you or another adult custodian opens an account on behalf of a minor at the financial institution of your choosing and invest as much as you like.They offer fewer tax benefits than the other savings programs. For children under 14, the first $750 of annual investment income is tax-free; the next $750 is taxed at the child's tax rate; income above $1,500 is taxed at the parents' rate. All income for children 14 or older is taxed at the child's rate. Also, when the beneficiary reaches the age of majority, he or she takes control of the assets—whether to pay for college or buy a sports car. In college financial aid calculations, UGMAs/UTMAs are considered the property of the student, so aid providers will expect up to 25% (for college aid) or 35% (for federal aid) of the assets to be used for college each year.

Saving for Retirement

      Personal finance experts have a rough rule of thumb about how much money you'll need in retirement. It states that to live comfortably, you'll need annual income that's at least 70% to 80% of what you were earning before you retired. This money will have to come from a combination of Social Security, pension or other workplace retirement plan, and personal investments.

People often underestimate how much they'll need in retirement savings. The retirement phase of your life will hopefully last decades, and although your investments will continue to produce returns during that period, you are likely to be drawing down your portfolio at the same time. Suppose, for example, that you plan to draw on your retirement savings for 30 years and expect to take a little more out each year so that your spending can keep up with inflation. To be able to ride out periods when the financial markets turn sour or inflation runs high, you probably should not spend more than 4% of your retirement savings in the first year. A little math shows that you'll need an initial nest egg of $500,000 if you want to be able to spend $20,000 in the first year, and to increase that amount by the rate of inflation in the ensuing years.

      The 4% withdrawal rate is another common financial rule of thumb. It is grounded in academic research, but it is not foolproof. For example, if you invest too conservatively and have a longer-than-average retirement, you could run out of money. I am admittedly conservative, so, when asked, I always suggest that people consider a more conservative 3% or 3.5% rate of withdrawal to ensure that they don't deplete their savings. (As an aside, any rule of thumb should be taken with a proverbial grain of salt. Your withdrawal rate, for example, should be personalized to your situation and reviewed periodically to account for environmental factors, such as market returns and inflation.)

      Fortunately, there are many ways to accumulate a nest egg for retirement. And today's savers have some rewards that their great-grandparents would have envied. Employer-sponsored retirement plans and Individual Retirement Accounts (IRAs) shelter your investment earnings from current taxes, which makes it much easier to accumulate wealth. With a company retirement plan, your employer may even supplement your savings with matching contributions, in effect giving you a pay raise that will grow and compound over time. The most common workplace plans include 401(k) plans, 403(b)(7) plans, and 457 plans, which are named for sections of the tax code that established them. You can also invest for your retirement by setting up an IRA with an investment provider.

      Your retirement savings bucket may be the biggest bucket you need to fill, but it also may be the easiest of the buckets to fill as long as you get an early start. If you start in your early 20s, building a retirement nest egg is more a matter of saving than investing. Time and the compounding of your investments will be bigger factors in your success.

      Here's a piece of advice: If you have a 401(k) or other retirement plan at work that lets you have savings automatically withheld from your paycheck, go for it. Contribute as much as the plan permits. If you can't make the maximum contribution, at least contribute enough to receive the full matching amount that your employer contributes, assuming that your employer offers a matching contribution. Then make it your goal to make the maximum contribution as quickly as you can.

      Portfolio Pitfall: Be Alert to Low Default Rates

      Many employers will automatically enroll you in the company 401(k), which is a good thing, since inertia precludes some individuals from signing up on their own. Automatic enrollments get workers in plans and help them begin saving at the outset of employment. However, many employers will automatically set your contribution rate at 3%, which is a bad thing. Nearly 40% of Vanguard plans have a default rate for contributions at 3%, which I believe is too low. You should set your sights on saving 10%–12%. Add to that the typical 3% match from your employer, and you are putting away a healthy 13%–15% of your take-home pay into a tax-advantaged account. If you join a company that features a 401(k) plan, be sure to check the default rate and increase it if necessary—even if the plan offers an auto-escalation feature that increases your savings rate each year.

Here's a strategy I frequently recommend as a very easy way to build a retirement program, and I'll use one of my colleagues, Jane, to demonstrate. When Jane began working at Vanguard, she contributed to the 401(k) plan at a level to receive the company matching contribution. Then, she gradually increased her savings rate by funneling an amount equivalent to half of each annual salary raise into her 401(k) until she reached the maximum allowable contribution. (Jane believed she could do this because her living costs hadn't increased