Thriving Millionaires

By Patrick

College has become what high school was decades ago. As children, we’re told that we can’t be successful without it. Most good careers or entry-level corporate jobs require some sort of bachelors degree. The only problem with this situation is that as college has become more of a necessity, it has also become more expensive. 

The average American today graduates with over $37 thousand in debt! Overall student loan debt in American surpasses $1.3 trillion. These numbers are astounding, and a great cause of concern for parents. It can be difficult for a young person starting off their career to also have to think about the massive amount of debt they are drowning in right out of the gates. 

Today, we’d like to start a two part series on how you can start saving for your child’s education. The first approach we are discussing covers some of the strategies you can use to start saving today! While you could just start putting cash aside in a savings account, there are other investment vehicles available to you that afford you potentially great returns, tax benefits, and other important features. 

Education Savings Account (ESA) or Education IRA

An ESA allows you to save $2,000 (after tax) per year, per child. This allows you to earn money from your investments and you won’t have to pay taxes on your earnings when you withdraw them. Now there are some income limits to qualify for this plan, and depending on how much money you want to save, $2,000 a year in contributions may not be enough for you. The beneficiary of this plan must use all of it by age 30. 

529 Plan

This is one of the more common investment vehicles when it comes to saving for college. Some of the key benefits here are that your contribution limits are much higher (around $300 thousand), and with some plans you can change the beneficiary of you want. This is important, because if your first child decides they don’t want to go to college, or gets a full scholarship, you can simply change the beneficiary. While there might be some restrictions, it’s better than losing it all! 

Now there are a few key things to keep in mind when choosing a 529 plan. Ideally, you want to find one where you can choose what investments are made through the plan. Also, look for one with some good historical context. This is an important investment you’re making, so you want to stick with something legitimate! 

Invest the money yourself

While this is certainly an option, there are some considerations to take in to account here. First, the above plans are great because they offer tax free benefits as long as the money is used for college. If you are relying on investing the money yourself, you could be subject to taxes you otherwise wouldn’t have. Now, if you feel that you could offset the taxes with your investment savviness, that’s a decision I’ll have to leave up to you! 

The second is that there may not be the same level of protections. When you create a designated 529/ESA account, you are assigning a beneficiary (your child) to that account. That provides a greater level of confidence that the money will actually be used for them. Life has a way of throwing out curveballs, so anything you can do to prepare is well worth it!

While the above strategies are just a handful of the ways you can save for college today, it’s important to note that not everyone will be in a position to do that. Before you start saving for your child’s college, you should make sure your house is in order first. If you aren’t actively saving for retirement, or have a significant amount of high-interest debt, you should probably take care of those things before you start investing in the above. While it’s great you’re thinking of your children, you won’t do them much good paying for their college and then just turning around and asking for their help in retirement! 

Eric’s Thoughts:

Saving for college is an incredibly tricky task because it requires you to be thinking about growing a pool of money with a finite amount of time in mind. This time constraint does exist with other savings objectives, but the hard end date is unique to college savings. For example, if you think about saving for retirement, you can find a way to work an extra few years if your financial house isn’t in the order you would want it to be when you leave your place of employment. Extending a career a few years is an option – asking your child to postpone their college education isn’t a real option for most.

Patrick does a nice job outlining the various financial vehicles that can be used for college savings, but I’d suggest that each family take a step back and first determine what level of support parents want to provide to their children relative to college education. Yes, it would be great to be able to provide a full-ride scholarship courtesy of the Parental Bank – but for many, that isn’t an option. In addition to being financially challenging to save that amount of money, the total sum is nebulous.

Will your child want to go to a state school or a private university? Will they want to start at a community college or jump into a four-year school? What if they choose post-graduate studies and extend their time at a university to get their master’s degree or even a doctorate?

These questions make “paying for college” a daunting task, and we haven’t even raised the question of equality across children. Assume you start saving aggressively when your first child is born, but when #2 and #3 come along, you can’t maintain the same savings amount for three accounts – what then? And what if #2 wants to get their PhD – do you pay for it? What about your other children?

Because of these tough questions, my wife and I have built a plan that will allow us to maintain fairness and still provide a significant (if not 100%) amount of financial backing when our children reach college-age. Here’s where we have landed:

When a child is born, we open a 529 with them as the beneficiary, and deposit a set amount of money in that account shortly after we return home from the hospital. From then on, we make additional deposits each year on the child’s birthday and on Christmas. The amounts that we have chosen allow us to maximize the tax benefits of the specific 529 plan in which we participate, but should still set our children up for success when they get ready to begin college.

The biggest curveball to consider when saving for college is that for any given 17-year period (birth to college enrollment) between 1958 and 2001, tuition inflation equated to between 6% and 9%. Specifically, between 2000 and 2019, tuition inflation averaged 5.2% per year.

Why are those numbers important? That means that a well-performing portfolio returning 5-7% will only keep up with tuition inflation. It won’t grow ahead of the projected expenses. Said differently, if a 4-year, in-state college costs ~$25,000 per year today, you would need to invest $25,000 today to pay for a year of college down the road.

I don’t say this to scare anyone (frankly, this was a sobering statistic for me to discover), but rather because it’s one that isn’t often talked about. We assume that if we save money for college and invest it properly, by the time our children are college-aged, we will be prepared thanks to the power of compound interest and investment growth. If historical trends continue, that assumption isn’t valid.

As with all things in personal finance, the most important thing is to start today: make a realistic plan, have open conversation about the plan, and work to save money towards this important objective. And if you’re looking to boost your savings – have you tried bringing your lunch to work?