The choice between applying savings to retirement versus to a child’s higher education (usually through a 529) is a common problem for most parents to encounter and work through. A good place to start is with the pithy saying, “No one will lend you money for your retirement.” At a high level, parents have a responsibility to make sure that they are going to be in a good position for retirement before they move on to helping their children with education expenses (even as we continue to realize the enormous burden that large student loans can put on young adults). In an extreme case, parents can risk becoming a liability on their children in retirement by prioritizing a child’s educational expenses over the well-being of their retirement nest egg.
At the same time, a 529 for a child’s higher education is an extremely valuable tool and can dramatically reduce long-term expenses. For example, when a baby is born, if the parents have $55,000 in cash to put into a 529 and assuming a 7% return, the child is expected to have about $210,000 for college. Almost everyone would rather “spend” the $55,000 now versus having to come up with $210,000 when college comes around. There are undoubtedly advantages to being able to start saving for college expenses early.
Deciding Where to Save in Three Questions
Here are the three questions we go through as practitioners to figure out whether and how much a family should save toward their children’s education.
- Is the family currently above or below path for retirement savings?
Very simply, if they are below path, they should prioritize their retirement. If they are above path, it may make sense to redirect some savings for a few years toward education.
Let’s start with an example. Assume a couple in their 30s with a young child makes about $150,000 combined (about $10,000/month after-tax) and spends about $8,000/month. This means that 30 years from now when they retire, they need enough income from their portfolio and Social Security to provide $16,000/month. (Assuming 2% inflation, $16,000 has similar purchasing power 30 years from now as $8,000 currently.) We don’t necessarily want to assume declines in spending in retirement.
The next question to answer is how much of that $16,000/month will come from Social Security/pensions and how much will have to come from the portfolio. If both parents are working at decently paying jobs, they are expected to receive anywhere from $3,000–$6,000/month per spouse in Social Security benefits (you can and should download your statement periodically at SSA.gov). In this case, we’ll assume that each spouse will receive $4,000 ($8,000/month combined) from Social Security. They will have taxes and Medicare Part B and prescription drug premiums withheld, so let’s say the net proceeds after taxes would be $6,000. Given that they need $16,000/month to live on, this means $10,000/month ($120,000/year) has to come from their retirement portfolio.
So how large does the retirement portfolio need to be and, in turn, how much should they be saving annually? A household can usually draw 4%–5% from their portfolio per year assuming it is invested appropriately and have the portfolio last through retirement. Let’s use the lower number of 4%. This means that their portfolio at retirement would need to be $120,000 divided by 4%, or $3 million at retirement. Assuming a rate of return of about 7% and that they have no investments currently, this means they would need to save about $31,000 per year for the next 30 years to hit their retirement goals. In this case, it would be unlikely that saving for college makes sense, because saving $31,000 per year for retirement needs to be the priority.
However, let’s assume that they did a great job saving in their 20s and currently have $250,000. Then the couple would only need to save $11,500/year to hit their retirement numbers. This means the family can probably continue to save some for retirement and may have the ability to direct additional savings toward education. As you can see, some retirement savings early in one’s career can allow for a lot more flexibility once children are in the picture.
- If they are above path with their savings, how much should they contribute to education?
This question is really dependent on the target for college savings (read Edmit CEO Nick Ducoff’s article in Barron’s on how he is thinking about the target). To continue with the example above, assuming that they only have to save about $11,500 for retirement but they are saving closer to $2,000/month ($24,000/year). Then, they have about $12,500 ($24,000 – $11,500) that could go to a child’s education. If they invest that amount yearly for the next 18 years (until college), they are expected to have about $425,000 in educational assets, which is probably too much. We aim with most of our clients to have $50,000–$60,000/year for college for four years (so targeting between $200,000–$240,000). This means that the family is expected to hit the target within 6–8 years and then they could redirect the savings to the next child or go back to saving more for retirement.
- Can saving for college through a 529 be a waste if the child doesn’t attend college?
We addressed the tax advantage of saving through a 529 versus a normal investment account in a previous article. There are some constraints and penalties if you are forced to withdraw the money for non-educational purposes. A non-qualified withdrawal will be taxed at the parents’ ordinary income rate plus a 10% penalty on any growth. Note that there are no penalties on the original investment, so the money is never trapped or wasted. It’s just that the growth could be taxed heavily if withdrawn for non-educational purposes.
This penalty rarely ever happens because individuals can change a beneficiary to any blood relative. Siblings, cousins or grandchildren can use those 529 assets tax-free. In fact, a number of clients have had their children finish college and still have a little money left over in the 529. We generally just leave it alone with the plan of changing the beneficiary to the grandchildren down the line (many of whom won’t be born for another 10–15 years).
Two Important Takeaways
Deciding when to start college funding and reduce savings for retirement can be a complex question, but what I hoped to provide in this article is some guidance that households can use to drive their decisions. Here are the key takeaways:
- Saving for retirement is critical and should take priority over funding a child’s higher education obligation.
- Once a household hits its retirement savings threshold, there are several factors that would determine how much to fund for higher education.
As an advisor, I find it difficult at times to tell clients that they need to focus on themselves before focusing on saving for their kids. Once the family is on the right path, early savings for college education is a powerful way to reduce and/or eliminate those costs down the line.
The information in this article is intended to serve as a basis for further discussion with your professional advisors. Although great effort has been taken to provide accurate numbers and explanations, this information should not be relied upon for making investment decisions.