Save or Take a Loan for Kids’ College Education?
It’s no secret that college is getting more expensive with no signs of slowing down. The average cost of tuition rose 37% from 2009-2019, and in that same period, student loan debt increased 107% to $1.6 trillion, according to this article on CNBC. Deciding on whether to prioritize saving – and potentially shortchange other goals – or use debt to fund kids’ college education is becoming more complex.
In this article, we’re going to cover the different options you have and what you should consider when thinking about saving for your child’s education.
Weighing the Choice to Save for College
As a parent, you want what’s best for your kids. Providing an education so that they can get started in life as debt-free as possible seems like the best thing you can do – but it’s not that simple.
It’s easy to immediately think that you should prioritize saving for your child’s future. But depending on your financial situation, this may or may not be the right choice. The biggest thing to consider is how diverting funds to pay for a child’s education will impact your own biggest saving goal: retirement.
If you’re currently behind on retirement savings or getting close to retirement and are concerned that you don’t have enough saved, retirement savings should be the priority. Children can easily borrow for education, and you always have the option of helping them out later on once your retirement picture is secure. On the other hand, trying to support retirement with borrowing, whether on a home or some other form of debt, is a risky and expensive proposition.
The decision to prioritize saving for college over retirement is usually made by younger parents who will have a significant amount of time to catch up on retirement savings after their children reach college age. However, nothing is guaranteed. Changes in health situations, job loss, or a career switch – all of these can derail the best intentions for retirement savings. And the earlier you start saving, the more you experience the power of compound interest in your retirement account.
The Best of Both Options
If you have the ability, you may decide to save for both retirement and college. If you choose to continue retirement savings and save for college, which plan do you prioritize? The decision comes down to several factors. On the retirement side, if you are eligible for an employer-sponsored retirement plan that offers a matching contribution, you of course want to save enough to get the match – that’s free money.
Since both retirement savings and college savings have the potential to offer tax benefits, it makes sense to be strategic about getting the most advantage. Both 401(k) contributions and IRA contributions can offer a tax deduction in the year they are made. Saving up to the maximum allowed can provide the most tax benefit.
This is true whether both spouses work or just one does – the spousal IRA option allows you to contribute to an IRA even if one spouse does not have earned income. After you have maxed out the retirement tax benefit, switching over to tax-advantaged education savings can continue to lower your tax bill while building up education funding.
Selecting a Savings Vehicle
When it comes to saving for college, you have a few options available and new laws over the past few years have made saving for college more attractive from a tax perspective. Savings plans also aren’t just for college – you can now use them for k-12 education too.
With 529 plans, you can contribute after-tax funds, the funds grow tax-free, and can be withdrawn tax-free when used for qualifying education expenses. Depending on your marital and tax filing status, you may be able to contribute up to $30,000 to the plan each year without incurring gift taxes. The nice thing about 529 plans is that grandparents can contribute to an existing plan or open another one and name the child as the beneficiary. You may even receive a state tax deduction when contributing, though not all states offer this benefit.
There are some common misconceptions about saving for education – if you’re going to apply for financial aid, the savings won’t lessen the award grant as much as you think. Colleges use the information you provide in the FAFSA to determine aid, and it’s based mostly on something called the “Expected Family Contribution.”
Because the investment timeline is much shorter, the investment strategy in a 529 is different from a regular investment account. Some plans even offer an automatic investment feature that may be familiar from retirement savings, called target-date funds. These strategies automatically lower risk as the date for college approaches, which can mean you have the potential for more growth earlier in the investment timeline.
Another way to save is a taxable investment account. These accounts don’t provide the same benefits of tax-free growth and withdrawals, but the funds can be used for anything and are not subject to any penalties. This account can be set up as a custodial account, but the child will gain full control of the assets at age 18, and from a financial aid perspective, assets held in the child’s name will count against aid grants more than assets held by the parent.
Going the Student Loan Route
College is expensive, and saving enough to cover the cost of four years can be challenging. Scholarships, grants, and work studies can help reduce the cost, but kids may still have to take out a loan.
The two main types of student loans are federal and private. Federal loans are typically preferred as they generally have lower interest rates and more flexibility when compared to private loans. Federal loans also may be forgiven if the child spends ten years working in a public service sector.
But there are situations where taking private loans is needed as well. Since kids most likely don’t have the credit to get a loan on their own, parents must typically cosign private loans. However, there are risks that come with cosigning. As a parent, you’re now responsible for the loan in the eyes of the credit bureaus. If payments are missed or the loan goes into default, your credit will be impacted. This can add significant stress to a parent/child relationship so cosigning a loan should be considered carefully.
Figuring out the best way to save for college while also saving for retirement is a struggle. Even if you may not be able to fully fund their college, every dollar saved is a dollar they don’t have to borrow. Take some time to evaluate your finances to determine if it makes sense to help save for college and if you need help, I’m more than happy to answer questions and help you build a plan to fund your child’s education goals.
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