If you have children or grandchildren, one of your main goals may be saving for their college education. The average growth rate for tuition at private universities was 3.7% in the 2014–2015 school year; at public universities, it was 2.9%. Over the past 10 years, college costs have increased on average by approximately 5% annually. While the growth rates for 2014–2015 are the lowest in 30 years, increasing costs still make it hard for many parents to effectively plan both for college for their children and for their own retirement.
One Client’s Dilemma
Fifteen years ago, one of our clients directed his savings plan toward his retirement. Now little ones are in the picture, and our client is saving for the children’s college and for his retirement. However, he is saving for college at the detriment of his own retirement. That’s because he is not making the full contribution to his 401(k) (plus the $1,000 catch-up contribution for those over age 50). He’s also not making the full contribution to his IRA along with the $1,000 catch-up contribution. Our client came to the realization that he was content with retiring at age 70 rather than 65 so that he could fully provide for his children’s college education.
A Delicate Balancing Act
Saving for college and retirement at the same time can be a difficult balancing act. For example, let’s look at two parents who have a newborn and who anticipate that their child will attend college at a University of California campus. In 2014, the annual cost of tuition, books and supplies, health insurance, room and board, and personal and transportation expenses was $33,100. In 18 years, four years of college will cost $413,308, assuming a 6% inflation rate on college tuition and a 7% rate of return.
At this rate, these parents would need to save $804 each month to reach the $413,308 goal. Please keep in mind that withdrawals from 529 plans are tax-free only if they are for qualified higher education expenses (QHEEs); insurance and transportation are not considered to be QHEEs. If withdrawals are not used for QHEEs, then the earnings on those withdrawals could be taxed as ordinary income and also incur a 10% federal penalty. Saving enough to cover all those costs is a tall order for most people, especially if they are also trying to save for retirement.
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Pay Yourself First
If funds are limited, which they are for many families, it is prudent for parents to pay themselves first and fund retirement before funding a college fund. Your child can always apply for financial aid, take out student loans, search out scholarships or work while attending school. Prioritizing your child’s college education is certainly a laudable goal, but not when you put your ability to retire at risk. You may be willing to accept the trade-off of funding your child’s college tuition by retiring at age 70 rather than age 65, for example. However, nothing is guaranteed. You could become disabled and no longer able to work from 65 through age 70. Or you could have to stop working before age 65.
Alternatively, your goal to fund your children’s college education so as to not burden them with debt could backfire. Contributing dollars to a college fund rather than retirement could mean using up resources that could otherwise be used to self-insure against a long-term-care event. In 2014, the annual median cost for a one-bedroom (single occupancy) in an assisted living facility in San Francisco was $51,300, $45,000 across the state of California and $42,000 across the U.S., according to Genworth. The median length of stay in an assisted living facility is 22 months, according to the National Center for Assisted Living. Health care costs are growing at 5.6% every year, which exceeds the average rate of college tuition inflation. In short, your children could end up being saddled with debt anyway if they need to provide for the costs of an assisted living facility for you or your spouse.
The Ideal Situation
Ideally, before you contribute to a college fund, you would have paid off all your debt, have three to six months of portfolio draws in cash (if still working) or three years of portfolio draws in cash (if retired), and have fully funded your IRA and 401(k). Also, keep in mind that there are some alternative—and cheaper—ways to pay for college. For example, rather than going to a four-year university right out of high school, it may make sense to go to a community college for two years and then transfer to another school to complete a bachelor’s degree. According to The College Board, California has the lowest community college costs in the nation for the 2013 and 2014 term at $5,696 in tuition and fees. Tuition and fees at a University of California campus are currently $13,300, or 133.5% more than at a community college.
Another strategy would be to save for 80% of the tuition and have your child work or take out a loan for the other 20%. While the 529 plan is a great vehicle for saving for college because of the tax benefits, such as tax-free growth and tax-free distributions if used for QHEEs, it may make sense to use a standard brokerage account to save. That’s because if your child does not end up going to college, then you can use those funds for retirement without incurring a 10% penalty. You receive no tax benefits, however, if you use the brokerage account for college education expenses. In addition, depending on how your projections for retirement look, Roth IRAs allows for qualified distributions without the 10% penalty tax if the distribution is less than or equal to the adjusted qualified education expense (AQEE).
In summary, please work with your financial advisor in projecting cash flow to get the retirement funding in place. Then focus on saving for a child’s college education.
Disclaimer: Consult your tax advisor before taking any action on topics discussed in the blog.