Saving for college - why it still makes sense
The 9 month wait is over and you have a child, what now? Unfortunately, sleepless nights are probably part of your new routine, at least early on. One of the things you may be counting at 3:00am (outside of sheep) is how much your new family member will cost you. A big chunk of this could be their college tuition, which somehow continues to rise by more than the cost of other goods (and general inflation). Then, there’s the question of education as a whole in the future - will college even exist? Although we don’t have the answer, we can still be nimble and plan ahead, earning ourselves some key benefits. Continue reading to learn how to approach college savings with a flexible plan that puts your racing, early morning financial thoughts to rest. As for the baby’s odd sleeping hours, you’re on your own…
Why save for college ahead of time?
There are a few solid cases to be made for putting at least some money aside for college before it’s time to actually pay tuition.
Your other goals suffer if you pay for college from cashflow at the time of enrollment.
If you plan to pay tuition from your income, there will most likely need to be some sort of compromise with savings and/or spending. In other words, you turn off retirement (401k/IRA) contributions for the 4 year period your child is in school. This would cost you the tax savings of those accounts plus any earnings on the investments.
For example, if college costs 30k/year then you could lose up to 20k of earnings (growth of 30k/year savings over 4 years) and 30k tax savings (resulting from tax deduction of 401k contributions).
Though, the losses don’t stop there. If you look at the growth of the would be savings over another 30-40 years thereafter (into retirement), you are down hundreds of thousands of dollars…not good.
You end up paying more if you use a loan (whether it’s in your name or the student’s).
This is obvious - though, you may not realize exactly how much more you pay over time.
Let’s say you have a loan of 120k (low end average of a 4 year public out of state school - 30k/year) and pay it off in 15 years (the average is actually closer to 20 years). The total interest paid over that timeframe is 70k for a total cost of about 190k. That means you paid almost 60% more than you had to.
You let compounding interest do some of the heavy lifting for you.
In other words, less comes out of your pocket and more comes from investment returns.
Continuing with the numbers presented above, you would need to save $300/month for the next 18 years to have 120k at the end. This means, you contribute a total of about 65k. This is about a third when compared to taking a loan.
Assumptions for examples above:
College savings earnings rate - 7% per year
Retirement savings earnings rate - 10% per year
Tax rate - 32% federal, 0% state
Student loan interest - 7% per year
Suggested vehicles to use
Now that we know it’s a good idea to have some sort of savings in place ahead of time, the next question is where to put those monies. Below, you will find some great options with the pros and cons of each. In addition to compounding interest (blog about impacts of investment growth over time), each of these vehicles offer great tax benefits (blog with breakdown of different tax terms) too - accelerating your progress even further.
529 Plan
Pros
Tax deduction in most states
Tax free withdrawals if used for qualified education expenses
Fair amount of exceptions if don’t need funds for college
35k rollover to Roth IRA
Can transfer to any other family member
Can pull amount of potential scholarship out without penalties
Cons
10% penalty and taxes on earnings if funds not used for qualified education expenses
Minor Roth IRA
Pros
Tax and penalty free withdrawal of contributions
Gives you flexibility as you can use funds for anything
Early start on retirement savings
If you keep earnings in the account, they will continue growing for the future
Cons
Can only contribute if your child has earned income
If contributions (portion of the account) are taken out early for education, this minimizes the impact of compounding interest for retirement, long term
Earnings cannot be taken out prior to retirement without a penalty and taxes
Brokerage (aka Taxable Account)
Pros
Lower tax rate on earnings (compared to a savings account)
Flexibility - can use the funds for anything at any time (contributions and earnings)
Cons
No tax deduction or tax free withdrawals (compared to the other two options)
How to break down savings to maintain flexibility
BUT, what happens if your child doesn’t go to school or college is no longer relevant in the future?
The answer…we don’t know. (Sorry, it’s the truth)
Like many other planning topics, we are unsure of how future social, financial, legislative changes may impact you. As a result, flexibility is strongly encouraged. Here is an example breakdown of savings that keeps you nimble, regardless of what the future holds.
40% of savings goes to a 529 plan
Major tax benefits and limited flexibility on use of funds (can only be used for education)
40% to a Minor Roth IRA (if you have the ability to contribute)
Big long term tax benefits and slightly more flexibility (only restricted on earnings portion of balances)
20% to a Brokerage account
Limited tax benefits - though, full flexibility with no restrictions on use of funds
In other words, if your goal is to save $300/month then $120 would go to a 529 plan, another $120 to a Minor Roth IRA and the remaining $60 to a Brokerage. It seems like a lot to manage, but you can easily set up these accounts once and automate the transfers to occur by themselves in the background.
What’s next?
Of course there is more that goes into college savings. A recurring theme (in comprehensive planning) is incorporating your core values and beliefs. Part of what forms this are your personal experiences - did you go to college? How did it impact your journey? Do you prefer your child take a similar or alternative path? These are all key questions we need to consider before crafting and implementing a Plan that makes sense for you. As always, Benzina is here to support you in the process - book a consultation session using the link below to see what this might look like for your family.