What Should My Coverdell Asset Allocation Be?

As back-to-school thoughts loom large over the dog days of summer, many of us are starting to think about education costs—from our 6-year-old’s new tennis shoes to her eventual college classes.

The Coverdell Education Savings Account is one of the two well-known tax-advantaged education savings accounts (the other is the 529 savings plan). One of the main benefits of the Coverdell is beneficiaries can use funds for any education level — not just college — and can even cover expenses such as school uniforms, tutoring, and transportation costs.

Those who already have a Coverdell often wonder what their asset allocation should be.  When people mention “asset allocation,” they are usually thinking of two investing principles: “Risk Tolerance” and” Diversification.” Both are largely influenced by the time until you need to use the funds for their intended purpose.

Risk Tolerance – “How much investment risk makes sense, and how much am I comfortable taking?”  Generally, greater risks  may lead to greater returns. And the more time you have to reach your goal, the more risk you can generally take since you theoretically have more time to recover losses.

However, just because you have the time to take on more risk, it does not mean that you should. If you are a risk-adverse person and will sell out of your investment when the market drops more than 5%, being in an aggressive investment with the potential to drop 40% is probably not right for you.

Diversification[1] – “How should I balance my portfolio to manage my risk tolerance?” A well-diversified portfolio is one of the best ways to manage exposure to risk. In other words, you don’t want all your eggs in one basket.

Now you see why these two principals are often used by the one term “asset allocation.” Your mix of stocks, bonds, and cash greatly influences your earnings — and the ups and downs you’ll experience along the way. If you have a diversified portfolio, it’s more likely that if one type of investment is doing poorly at a given time,  another might  be performing  better. 

Now, let’s apply this to your Coverdell by answering these two questions:

1. How long until I need to use the money?
2. How much risk am I willing to take?

   The last thing you want to happen is needing to withdraw $2,000 from your Coverdell account to pay a school bill, only to find out that its value has dropped 40% in the past year and you don’t have time to let it recover. The closer you are to needing the money, the more conservative you probably need to be.

   At USAA, we often see our members forgetting that last sentence and staying too aggressive too long. Unlike a target retirement fund, which automatically adjusts asset allocation to grow more conservative over time as you approach retirement, the responsibility to set the proper asset allocation to manage risk within your Coverdell is all yours.

   With that in mind, a simple way some people manage their asset allocation is to start out more aggressive where their portfolio contains a higher percentage of stocks and then slowly reduce their stock exposure in order to adjust risk downward to become more conservative as they get closer to needing the money. 

Have you reviewed your asset allocation in a while? I recommend looking at your account to determine if your risk is where you want it to be. If you haven’t started saving for education expenses, USAA’s Education Saving Planner webpage can help you get started.

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[1] Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.