Ever since I published this post — Why I don’t like Investment Advisors — people have somehow gotten it into their heads that I don’t like investment advisors. Go figure.
And ever since he first interviewed me on his podcast, Radical Personal Finance, my financial planner pal Joshua takes me to task for this. He assures me, with great passion, there are many good, competent and honest advisors who genuinely put the needs of their clients ahead of their own. Joshua knows this because he is one and, not surprisingly, he hangs out with others in the profession who are as well. This colors his view.
I, on the other hand, am routinely regaled with mistreatment horror stories about advisors from my readers and friends. Stories that range from the grossly incompetent to the purely self interested to the outright fraudulent.
This colors mine, and even Joshua concedes it is a profession that attracts some of the worst sorts and finding one of the good sorts can be a challenge. Not terribly surprising when you consider it is a profession that gives access to the life savings of potential
marks, er, customers.
That said, when they are good they are invaluable resources. Especially when they are deeply knowledgable and wicked smart.
My other pal Matt, of Mom and Dad Money, is one such. (That link, BTW, will take you to his recent post on “Uncertainty.” A great read on an important concept.)
Tools for college saving
More and more frequently in the comments here I get asked about the tools specifically designed to help parents save for college. While I’ve answered as best I can, it has been a long time now since we saved for our own daughter’s education and I’m just not all that interested in keeping up on the subject.
So I was delighted when recently Matt put up a series of posts on college savings plans:
- Reasons NOT to use them
- Reasons TO use them
- and How to choose
These posts were comprehensive, very well done and solved my problem. I simply created Addendum #3 in my post The College Conundrum, linked to them and started sending people there.
But the more I thought about it, the more important this issue seemed. Paying for college is, after all, an increasingly challenging financial task. It needed its own post here and in Matt I’d found just the guy to write it. Fortunately, he graciously agreed.
As you’ll see, he not only takes you thru all the savings options and tools, he also presents entirely new concepts and approaches most have never even considered.
Here it is.
Everything You Need to Know About Saving (or Not!) for College
by Matt Becker
You have to start saving for college as soon as you have kids, right?
That’s how most of the parents I work with feel when they first come to me. And it’s an admirable sentiment. It comes from caring about their children’s future and wanting to provide them with all the opportunity in the world.
It’s also a feeling I know well. One of the first things I did for both of my boys was open a 529 plan and start making small monthly contributions.
But as a financial planner, it’s usually my job to pump the brakes a little bit.
Because while saving for college is a fantastic goal, it’s almost never the most important one. And even if you have all the money in the world, there are good reasons to consider alternative approaches that can open up even more opportunities for you and your children.
In this post we’ll get into all of that and more. Here’s what we’ll cover:
- Why you should consider NOT saving for college
- When saving for college IS a good idea
- How to save for your child’s future as efficiently as possible
Let’s dive in!
5 Reasons Why You Shouldn’t Save for College
It may be that the smartest financial decision you can make is to not save for college at all, at least in the traditional way.
Here are five of the biggest reasons why that’s true.
1. Other financial priorities are more important
In an ideal world you would have plenty of money to help your child pursue whatever opportunities she wanted. In other words, having the money to pay for college (or anything else) is preferable to not having it.
But most of us don’t have unlimited resources. Most of us have a finite amount of money and we have to make tough decisions about how to prioritize it.
And from a purely logical standpoint, it almost always makes sense to prioritize a number of other financial goals over saving for college.
To start, there are many ways to pay for college that don’t involve a huge amount of savings, including:
- Paying from cash flow (like any other bill)
- Taking on student loans (potentially high ROI if done thoughtfully)
- Applying for scholarships and grants
- Taking a less expensive route through college
- Having your child work part-time to help with the cost
Other financial goals don’t have that luxury. Most of them are either dependent on your ability to save or require you to spend money on them now.
Here’s a list of financial goals I typically encourage my clients to prioritize over saving for college:
- Retirement/financial independence
- Emergency fund
- Life and disability insurance
- Estate planning
- Paying off debt
Even beyond that list, you may want to put goals like traveling, buying a house, or starting a business before saving for college, if those things are important to you. Because again, those things will only happen if you dedicate money to them now.
2. Give your child skin in the game
I said above that in an ideal world you would have plenty of money to help your child pursue whatever opportunities he wanted.
But maybe you don’t think that’s true. Maybe you would prefer for your child to have some skin in the game when it comes to education.
There’s nothing like having to put money on the table to make a person take something seriously. Your child may end up getting much more out of college if he is required to invest in it himself.
3. The tax benefits may be small
The tax benefits of dedicated college savings accounts are often overstated.
Let’s say you save $100 per month for college from the day your daughter is born until the day she turns 19. And let’s say you earn a 4% annual return on that money over those 19 years, representing a mix of aggressive investments when your child is young and conservative investments as she nears college.
In a 529 savings account, where your money grows tax-free and can be used tax-free for qualified higher education expenses (more on that below), you would have $34,181 to put towards your daughter’s college education.
In a regular investment account with a 15% tax rate on earnings (for simplicity’s sake), you would have $32,474.
That means you would save $1,707 on taxes by using a college savings account. Not insignificant. But probably not life-altering either.
And it comes at the cost of that money being subject to extra taxes and penalties if it’s not used for higher education.
Quick note: The savings will be greater if you live in a state that offers an income tax deduction for contributions. That should definitely factor into your decision.
4. What will college look like in 10-20 years?
I honestly have no idea what higher education will look like in 14 years when my oldest son is 18.
Will it be astronomically expensive, as recent trends would indicate?
Will it be free?
Will online learning be the norm? Or will it at least push down the cost?
Will it make more sense to start a business or get an apprenticeship?
With all of that uncertainty, there’s a level of risk in putting a significant amount of money into an account that’s primarily meant for only one of those scenarios.
5. You can invest in your children now
Joshua Sheats, a financial planner himself, has a fantastic podcast episode on this exact topic, explaining all of the reasons why he personally is not saving for his children’s college education.
My favorite reason is that college is a small four year window in your child’s life. Why would you divert so many of your resources to that small window when you have 18+ years before then to help your child build skills and interests that will serve him well for his entire life?
How about using that money to travel to new places that expand his understanding of people and cultures? What about spending it on activities and coaching that develop core skills nurture his biggest interests? What about helping him fund a small business so he can learn what it takes to produce something of value and create his own financial resources?
Or how about this: build up your own F-You money so that you have time to spend with him. After all, there’s nothing a child needs more than quality time with his parents.
There are many ways to invest in your child’s future. College is simply one of them.
4 Good Reasons to Save for College
All of that makes saving for college sound like a pretty bad idea, doesn’t it?
Of course that’s not the case. There are plenty of situations where it makes sense and where the benefits a dedicated college savings account can be significant.
Here are four reasons why saving for college can be a good idea.
1. Other financial priorities are handled
Let’s say that you’re on track for retirement, you have a strong emergency fund, good insurance, a solid estate plan, no debt, and you’re even able to enjoy yourself from time to time.
If you have extra money to put somewhere, what should you do with it?
There’s no right answer to this question since it really depends on your personal goals and values. But investing in your child’s future is certainly a worthy cause.
2. You can contribute a lot of money early on
If you can contribute a significant amount of money early in your child’s life, the tax benefits of a dedicated college savings account can be substantial.
Let’s say you can save $500 per month for college. Using all of the same assumptions we did earlier you’ll end up with $8,536 more in a college savings account over a regular investment account because of the tax breaks.
And to get even more extreme, let’s say that you and your spouse save $28,000 per year (the maximum you can contribute in most cases without triggering the gift tax) for the first five years of your child’s life and then stop contributing.
In a dedicated college savings account you would have $273,126 of tax-free money to put towards your child’s education. In a regular investment account it would be approximately $253,157 after-tax. That extra $19,969 would certainly come in handy.
3. You place a high value on traditional college education
You can follow all the financial “rules” you want, but in the end your money will only bring you happiness if you use it on things you value.
If having the ability to pay for your child’s college education is one of those things, then this is a fantastic use for your money. Not only are you providing your child with the gift of choice, but you’re increasing your own happiness in the process.
Most college savings accounts are fairly flexible. You can use the money on a traditional undergraduate degree, advanced degrees like a master’s or doctorate, and even certificate programs like the one for the CERTIFIED FINANCIAL PLANNERTM certification.
And if one child doesn’t end up needed the money, you can use it for a different child. Or for yourself, or a spouse, or a niece or nephew, or a grandchild.
So while there are restrictions around college savings accounts, they are also more flexible than you might think. There will almost always be a way to put the money to good use.
How to save for your child’s future
If you’d like to start saving for your child’s future, whether that’s college or something else, what’s the best way to do it?
Here’s an overview of the different types of accounts available to you and the pros and cons of each one.
Traditional college savings accounts
529 plans are what most people think of when it comes to saving for college, and for good reason. They offer some pretty significant tax benefits in the right situations.
From a tax perspective, 529 plans work much like Roth IRAs but for college instead of retirement. Money you contribute grows tax-deferred while inside the account and can be withdrawn tax-free for qualified higher education expenses.
Some states even offer a state income tax deduction for contributions if you use your home state’s plan (there is never a federal income tax deduction).
Another big benefit is that there are NO income restrictions to prevent you from using them. They are open to everyone.
And you can contribute a lot of money.
Most plans have a maximum cumulative contribution of several hundred thousand dollars that most people will never get near. On an annual basis your contribution is only limited by your willingness to exceed the annual gift tax limit. For 2016 that limit is $14,000, which means that you could contribute $14,000 for each of your children without any gift tax consequences. For a couple it’s $28,000 per child.
There’s even a special 5 year election rule that allows couples to contribute up to $140,000 in a single year if you’d like.
The biggest downside to 529 plans is that if the money is withdrawn for any purpose other than higher education, the earnings are taxed as ordinary income and subject to a 10% penalty.
The other downside is that you’re limited to the investment options within the 529 plan, and some states offer some pretty dreadful choices.
The good news is that you’re under no obligation to use your state’s plan. To check other options, Morningstar produces an annual ranking comparing various 529 plans.
When I work with clients, I always check their home state’s first to see what tax benefits it offers. But if there aren’t any in-state benefits, my go-to recommendations are usually New York, Utah, and Michigan.
A Coverdell ESA is a lot like a 529 plan in that it offers tax-deferred growth and tax-free withdrawals for education expenses.
The big advantage of a Coverdell ESA is that the money can also be used tax-free for K-12 expenses. So if you want to enroll your child in private school or even pay for some tutoring, a Coverdell can help.
The big downside is that you’re limited to a maximum per child contribution of $2,000 per year and there are income restrictions that prevent higher earners from using these accounts at all.
Here’s a list of providers that offer Coverdell ESAs.
You CAN contribute to both a 529 plan and Coverdell ESA, assuming that you’re within the Coverdell income limits. Keep in mind though that those contributions are combined for the purposes of the annual $14,000 gift tax exclusion.
From JLC – Note 2:
For more on Coverdells, check out this conversation from the comments below. It also touches on 529 plans and UGMA/UTMA accounts.
Non-Traditional College Savings Accounts
Regular investment account
A regular investment account doesn’t come with any special tax benefits, but it does offer some other big advantages.
First, you can contribute as much as you want and invest however you want. You have total control.
And second, the money is accessible for any purpose at any time. That means that if life changes and you’re suddenly in need of cash, this money is available to you without any penalties.
It also means that you’re free to use this money to invest in your child in whatever way you see fit. If you want to use it for college, then great! If you want to help them start a business or travel the world, then great! And if you want to use it as F-You money so you can reduce your work hours and spend more time with your family, it’s there for that too.
A regular investment account gives you the most freedom to provide the opportunities YOU want to provide, no matter what they are.
A Roth IRA combines some of the flexibility of a regular investment account with some of the tax benefits of a college savings account.
- The money is tax-deferred while inside the account.
- The amount you’ve contributed can be withdrawn tax and penalty-free at any time for any purpose.
- The earnings can be withdrawn penalty-free for qualified higher education expenses at any time, though they will be taxed as ordinary income.
- And of course, if you don’t need the money for college you can simply keep it inside the Roth IRA and use it for retirement.
But there’s another way to use a Roth IRA that can be both a teaching tool AND a fantastic way to invest in your child’s future.
Anyone with earned income can open and contribute to a Roth IRA. That includes children. So why not do something like this:
- Encourage your child to find a job or start a mini business.
- Maybe even use some of that money you put in a regular investment account to help her get this going 😉
- Agree to match some percentage of her earnings with contributions to THEIR Roth IRA.
- Invest those contributions together, giving your child hands-on investing experience.
- When your child reaches adulthood, she will have a fantastic head start on retirement and it will be directly because of her hard work.
I’m not a fan of…
…using UGMA or UTMA custodial accounts. Here’s why:
- There are no tax benefits.
- The money is irrevocably your child’s as soon as you contribute it.
- They have a negative impact on financial aid.
- Your child can use the money however they want once they become an adult, which means they may or may not use it for college.
Note from JLC:
For more on UGMA/UTMA accounts, check out this conversation from the comments below.
The Best Solution for YOUR Personal Goals
Whew! That was a lot. So here’s a quick summary of how I encourage my clients to think about this question of saving for their child’s future.
First, handle other financial priorities like retirement, your emergency fund, insurance, estate planning, and debt.
Then, consider the following questions:
- What kind of person do you want to raise?
- What qualities, skills, and values would you like to pass on?
- What types of opportunities and experiences can help foster those things?
- How can you best provide those opportunities and experiences?
- Which financial tools will help you provide those things most efficiently?
If your answers lead to a traditional college savings account, then great!
But there are many options available to you and I would encourage you to be creative about the best solution for YOUR personal goals.
Here’s a link to the spreadsheet used to run the numbers in the scenarios above: https://momanddadmoney.com/college-tax-savings.
Matt has also graciously agreed to answer any questions you might have. Ask away in the comment section below!
Course: 10 Weeks to a Better Future
If you are as impressed with Matt’s clarity of thinking and presentation as I am, check out his course. It walks you step-by-step through every major financial decision you have to make as you start your family so that you can stop worrying about money and start using it to build a better life.
Will saving for college impact your child’s eligiblity for financial aid? (Another great example as to why the comments around here are so valuable and so worth your time.)
Recently I was interviewed by Hahna Kane for the Master Your Money Summit. We had a blast!
Here are some more: As Seen On
What I’ve been reading recently and recommend:
We all know the Wright Brothers invented the airplane. But I, for one, had no idea how compelling a story theirs is. At least as told in this book by Mr. McCullough. Reads like a novel.
One in a series of novels and short stories recounting the adventures of Bertie Wooster and his “gentleman’s gentleman” Jeeves. If you’ve not read Wodehouse, do yourself a favor.
Aging boomers are urged to kill themselves to save the government money. A humorous cross between Jonathan Swift’s “A Modest Proposal” and “House of Cards”
Interestingly, it references Bertie Wooster.
Southern missionary packs up his family and heads to the Congo. It doesn’t go well. Narrated in rotating chapters by his wife and four daughters. Compelling tale very well told. Amazing as the style and tone shifts between her narrators.
True story of a Mexican fisherman blown out into the Pacific Ocean and his survival as he drifts across for, well, 438 days. Reads like the great adventure it is. Amazing to note: All of his supplies are lost in the storm but he comes across enough garbage floating in the ocean to replenish them.
Predicting the future is risky business, but Ross makes an interesting case for how markets are changing and what industries are driving the change. Given the current political debate here in the US, I especially enjoyed his section: The Geography of Future Markets.