Tuesday December 11th 2018

Paying Tuition and Living Expenses from a Lump Sum

Case Western Reserve University. Cleveland, Sept-2009.
Photo by Standard Travel Fotos

A hypothetical reader writes:

I am a 21 year old college student and will graduate in 3 years with a BSEE degree. My parents passed away and I inherited $500,000 which is sitting in my bank account. I have to pay for tuition and books which amounts to about $20,000 per year. My total living expenses are $2,500 per month including $1,000 rent, utilities, food, transportation and entertainment. I am in good health.

When you graduate in three years, you should be able to get a job as a salaried electrical engineer. The typical starting salary for an electrical engineer is about $60,000 per year. Meanwhile, since you have no one else to support you, you will have to use the $500,000 to pay your tuition and expenses for the next three years.

Your total annual expenses for the next three years is 12 * $2,500 living expenses plus $20,000 tuition equals $50,000 per year. It will be necessary to draw this from the $500,000 sum. Dividing $50,000 by $500,00 gives a starting withdrawal rate of 10%. The is a high withdrawal rate, so you can expect to draw down the sum. Over three years, there will be a total withdrawal of $150,000.

College Tuition
About $60,000 of this will be three annual tuition payments. Assuming that $20,000 tuition is paid once per year, take $60,000 and set up a CD ladder that has a CD maturing when the tuition bill comes due. For example, if tuition is due 12, 24 and 36 months from now, buy a 1, 2 and 3 year CD.  This way the money will be available when you need it, and in the meantime you’ll earn some interest on the money. You can get FDIC-insured bank CDs at a local bank or NCUA-insured CDs at a credit union. Check for the best CD rates.

That covers your annual tuition bill. Now set up an income stream to fund your monthly living expenses.

Withdrawal Mechanics for Monthly Expenses
First thing is to establish the mechanism for withdrawing money to pay your bills. Normally you pay your bills from your checking account. Every month you write a rent check to the landlord, pay your electric and gas bills, pay you credit card balance, withdraw cash from the ATM using a debit card, etc. So you need $2,500 going into your checking account every month. Ideally, this will run on autopilot using automatic transfers.

The way to do this is to move the entire remaining $440,000 sum to a place like Vanguard. From here on, let’s assume that you will use Vanguard. The process is basically the same for another place like Schwab and Fidelity.

The $440K will initially go into a money market mutual fund (mmmf) like Vanguard Prime Money Market Fund (VMMXX) or Vanguard Tax Exempt Money Market Fund (VCTXX). Since this is a taxable account, it probably makes sense to use the tax exempt money market. Vanguard also offers tax-exempt money market funds for California, New York, New Jersey, Pennsylvania, and Ohio.

Set up an automatic transfer of $2,500 each month from the money market fund into your checking account. This is your monthly income for the next three years until you graduate and find a job.

Keep about four months of expenses, or $10,000, in the money market fund. The next thing is to set up a CD ladder re-fill the money market fund.

Refilling the Money Market Fund from a CD Ladder
Monthly withdrawals would deplete the money market fund in about 3 months. So you have to keep refilling it. The way to do this is to set up a 3-year CD ladder with rungs every three months. Each CD has face amount of $7,500. There’s a $7,500 CD at 3, 6, 9, 12, 15, 18, 21, 24, 27, 30, 33 and 36 months. That’s 12* $7,500 = $90,000 in CDs. Every 3 months, a CD in the amount of $7,500 will mature and the proceeds will automatically go into the money market fund.

You can purchase brokerage CDs from Vanguard Brokerage Service. Brokerage CDs are slightly different from bank CDs. Interest is not reinvested and you can’t break them early. You can sell them, but you don’t want to because you’ll get a lowball price from the traders. You should hold them to maturity.

Once you have this set up, it should run on auto-pilot for the next three years. You should check on it, but should not have to do anything.

Invest the Rest
$60,000 went into a CD ladder for college tuition. Another $90,000 went into a CD ladder for three years living expenses. That leaves $350,000 of the original $500,000 that can be invested in longer term, and riskier investments.

What kind of long-term portfolio to invest in? That’s another topic.

Margin of Safety
You might want to consider extending the CD ladder another couple of years, just in case you decide to get a Masters or if it takes longer than expected to graduate or to find a job.

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