Recently, I posted a simple question on Facebook: “What’s the biggest personal finance struggle you have currently?” My goal was to check the pulse of what real people were dealing with when it comes to important decisions about money. Thankfully, I received many good responses that may be the inspiration for future posts, but one in particular stood out as an important question to which, I feel, there is a pretty clear-cut answer. It came from my college friend Brenda, who wrote: “If we had to choose, what is more important, saving for college for our children or retirement for us? With one income we have to make hard choices.”
Many parents find themselves in a similar predicament. Very few families have enough income to avoid making hard choices regarding how to allocate their resources. While these choices may be a matter of scale—some have to choose between private school tuition or exotic family vacations while others may face more mundane choices between such things as healthier school lunches or a new bike, for example—the feeling is the same; disappointment and perhaps even guilt that we cannot give our kids everything they want or need.
If there is not enough free money in the budget to save both for our retirement and the kids' college, which one do we choose? On the one hand, we all know that starting to save early is an important key to being ready for retirement. None of us wants to be a burden to our kids one day because we did not set aside enough in our working years. On the other hand, we all know the research that shows that a college education is important to future financial security. (For related reading, see: The 8 Deadly Sins of Financial Advice.)
The standard answer we typically give to general budgeting and cashflow issues is that it is a matter of priorities. And there is no textbook financial answer when choosing between priorities, it’s just a matter of what is most important to you. Do you want to save more now so you can retire earlier or spend more now and therefore retire later? To a large extent this a matter of personal preference. Part of our job as a "personal CFO” is to come alongside our clients to help them understand the consequences of those decisions, but not to make the decisions for them. (A personal CFO is analogous to the corporate CFO, who provides the numbers and analysis to the company CEO, who ultimately weighs the company’s priorities and objectives and makes a decision.) However, this may be one of those questions for which prioritization alone may not be adequate. For many families, it is impossible to simply prioritize one goal above the other because both goals are vitally important, and there simply isn’t enough extra income to go around.
So with those thoughts in mind, here are some general guidelines that may make the decision easier. Bear in mind that to fully understand the decision and make a prudent selection would require an analysis specific to your situation.(For related reading, see: 6 Life Events That Call for Professional Advice.)
You Can Finance College, but Not Retirement
As a general rule, you can borrow money for college, but not for retirement. There are plenty of public and private sources for college funding available should your son or daughter need it. Yes, there are all kinds of problems with student loans in general, which are beyond the scope of this post, but the point is that you can access funds for college somehow, someway. The same cannot be said of funding your golden years. And while graduating from college without student loans is an important goal, sometimes it just isn’t possible. What’s more important is to make sure students get a degree that qualifies them for a job with enough income to pay back the debt, if any. On the other hand, there is no borrowing money to pay your heating bill at age 80.
Starting Early When Saving for Retirement is Vital
The math on compounding interest is compelling. Consider this: if you start saving in your twenties for retirement in your sixties, a consistent 10% savings rate may be enough to meet your needs. While that 10% you are saving may not seem like much early on, compounding interest over long periods of time can work magic. For example, let’s assume you are 25 years old and married with a combined income of $60,000 a year. By saving just 10% of that income, or $6,000 a year (just $500 a month), you would have about $1.7 million dollars by age 65, assuming reasonable rates of return based on historical data. (For more, see: The Awesome Power of Compounding.)
By contrast, if you wait to start saving for retirement in your mid-thirties, you need a savings rate more than double that to reach the same amount at retirement.
Don’t Pigeon-hole Your Child or Your Money
One of the downsides of education savings accounts, such as 529 plans, is that the money is specifically designed for a future goal that may or may not occur. This is not true of retirement. At some point all of us will retire, whether we want to or not. And while probably everyone wants to think that their child will go to an Ivy League school with a 4.0, the truth is not every student needs or wants a traditional college degree. Some may decide to start a business, become a police officer or firefighter, or even enter the military. We can all think of famous businessmen, such as Mark Zuckerberg or Bill Gates, who never finished college. There are still many rewarding careers that do not require a formal college degree, such as becoming a welder, plumber, realtor or an air traffic controller.
And while it’s true that should your son or daughter earn a scholarship you can pull funds out of a 529 plan penalty-free, the same cannot be said of if they simply decide that college is not for them.
Don’t Forget About Education Tax Credits
As a general rule, the tax code encourages middle class families to send their children to college by offering valuable tax credits such as the American Opportunity Credit. These are tax credits, which are far more valuable than simple tax deductions, and when it comes to education planning they are often overlooked. But it's very important to understand the rules because the tax code restricts you from taking education tax credits and withdrawals from education savings vehicles in the same year. The point is that by planning ahead and funding a 529 plan, for example, you may be eliminating your ability to get this tax credit.
And, although the AOC, for example, is only $2,500 a year, if you run the numbers, you may find that it is worth as much as or even more than the tax benefits on the average 529 plan account. Now if your income is over certain limits these credits do get phased out; so if you’re in that category, the 529 plan (and other college savings options) start to look more attractive. (For related reading, see: How to Protect Family Finances When a Child Makes a Mistake.)
Look for Lower-Cost Educational Options
Although college costs are rising, you can still get an education affordably if you do the right research. For example, some states have partnership programs between two-year community colleges and larger universities, allowing students to transfer into the more expensive university after two years of much more affordable costs at the local community college. In addition, there are many online universities that offer fully accredited degrees at a fraction of a traditional college, and he/she can save on living expenses if willing to live at home while attending college online.
The Bottom Line
I think we can safely say that, for most people, it makes more sense to focus on saving for their own retirement first before focusing on college savings for the kids. To borrow from the airline industry, “passengers should always fit his or her own mask before helping children, the disabled, or persons requiring assistance,” and parents should always fund their own retirement first. That said, we are not against college savings accounts, and in fact recommend them for many of our clients. Every situation is different, and in some they make a lot of sense and add real-world value. So, I would encourage readers to seek professional guidance before making this important decision, since there may be additional items of consideration for your unique circumstances. (For more, see: Student Loan Debt: What Every Borrower Should Know.)
This article originally appeared on the JPH Advisory Group blog.