Why Mutual Funds are the Worst Way to Save for College

Saving for college in mutual funds that are not sheltered within a 529 or another non-assessable account can have a huge impact on your Expected Family Contribution (EFC). Here’s what you need to know when using mutual funds for college savings.

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Mutual Funds Create a Double Assessment

Mutual funds for college savings are not only assessed as an asset at 5.6% to determine your EFC but the internal capital gains, dividends, and interest income are also assessed as income at 47%–a much higher rate than the asset assessment!

It’s the latter assessment, of course, that can really do serious damage to your EFC and raise the overall cost of college.

Comparison of Unsheltered and Sheltered Mutual Funds

Let’s assume you are holding $80,000 in mutual funds that generate $10,000 in capital gains and $800 in dividend income during a given calendar year.

What you pay for college will vary greatly depending on where those mutual funds are held:

$80,000 Savings in Unsheltered Mutual Funds =  $9,588 Increase in EFC

$80,000 Savings in Mutual Funds Held within 529 = $4,512 Increase in EFC

$80,000 Savings in Mutual Funds Held with a Roth IRA = $0,000 Increase in EFC

Hidden fees in Mutual Funds can also wreak havoc on your retirement savings

For many years the hidden fees on money held in mutual fees did not get much attention. Indeed, most investors I have met over my 25 years as a financial planner still assume a cost of about 1.25% per year for their mutual funds. Unfortunately, this doesn’t begin to tell the whole story.

In a recent Forbes article, one investor discovered that her advisor was actually earning $70,000 a year on her mutual funds account even though her statement said it was just $20,000. That’s a whole lot of hidden fees!

What Does this mean for the Average Middle-Income Investor

It means a whole lot of money when using mutual funds for college savings. The total hidden fees for an investor with a small $10,000 investment and a 7% compounded growth over 30 years would actually spend about $200,000 in hidden fees.

Barron’s reported on a 2013 study revealing that trading fees alone in small-cap stocks can add another 3.17% per year to the total cost.

Hidden Fees are not limited to trading fees!

The mutual fund industry is a powerful one that supports a big PR machine to keep money flowing into the coffers of thousands of funds. Until recently the mutual fund industry has been able to keep all this nasty talk about hidden fees out of the press.

That’s why I was pleased to see a recent article in US News (which represents the public rather than the financial industry) finally reveal the many hidden fees that investors are paying year after year from their mutual fund investments:

Expense Ratio: 125 basis points

Cash held to maintain liquidity: 83 basis points

Average transaction costs: 144 basis points

Additional broker commission: 25 basis points

Bid-Ask Spread: 23 basis points

Negative Impact Costs: 96 basis points

Taxes: 100 basis points

All of these hidden fees create an all-in cost of 4.52% for a taxable investor or 3.52% for non-taxable accounts according to U.S. News.

Bottom Line

If you add the many hidden fees to the loss of financial aid from your higher EFC assessments, I’m sure you agree that you can only conclude that using mutual funds for college savings are possibly the worst way to save for college.