What’s more important, your retirement or your child’s college education?
Financial planners generally suggest that the former should receive priority, but many parents also want to plan for their children’s higher education.
While financial priorities are a matter of personal choice, parents need to keep things in perspective. If you don’t have sufficient assets or a pension, there are limited options other than Social Security and continued employment for funding your retirement.
On the other hand, there are various funding sources for college, ranging from loans and scholarships to summer jobs and, in many cases, gifts from grandparents.
Another important consideration is whether you want to be financially self-sufficient in retirement, or whether you want your children—who may be trying to raise their own families—to help support you as well.
The best strategy for your family overall is for you to stay financially healthy, so your first priority probably should be investing for your own future—unless you live very modestly and know that you can rely on a substantial pension to cover your needs in retirement.
Nevertheless, saving only for retirement is not very appealing to most parents. They want to save for college as well.
What are the various options that are available for saving for both retirement and college?
T. Rowe Price analyzed various savings strategies to compare the possible implications of different approaches to investing for retirement and college simultaneously. The results, shown in the chart, are for comparative purposes only and do not indicate how much someone may actually need to save to meet his or her individual college and retirement savings goals.
The examples make these assumptions:
- The parents have a combined income of $100,000, which increases 3% annually;
- They invest 6% of their salary each year over a 36-year time period (18 years prior to the child starting college and 18 years from the start of college until the parents retire);
- Savings earn an average annual 8% pretax return;
- Retirement savings are invested in a 401(k) plan and college savings in a 529 plan, where unlike the 401(k), they could be withdrawn tax-free.
Investing Only for Retirement
If the couple invests only for their own retirement over the full 36-year period, their retirement nest egg would be worth nearly $1.7 million, assuming their 401(k) plans offered no matching contributions.
If their plans provided a 50% match, the amount accumulated would be more than $2.5 million.
Given the potential boost provided by a company match, investors should certainly factor this in when choosing a savings strategy. Note, however, that all money in the 401(k) would be subject to taxation upon withdrawal in retirement.
One at a Time
The second scenario involves saving only for retirement until college begins, then using the full annual savings amount for the next 10 years to repay a college loan at 5% interest. After that, the couple reverts to saving exclusively for retirement over the final eight years.
This strategy produces the lowest amount available for college. However, the amount available at retirement is only 20% less than if the investor had saved exclusively for retirement for the full 36 years.
Thus, even though the couple temporarily ceased funding retirement for a decade, they were still able to benefit significantly from the long-term compounding of the investments made during the first 18 years.
A Dual Approach
What if this family decided on a dual approach?
The third scenario splits the annual investment between college and retirement until the child starts college. After that, the couple would invest only in their retirement funds.
In this instance, the couple would accumulate less for retirement than the first two scenarios, but more than twice as much for retirement as compared to the last scenario (putting college first—see below), although the college fund would be worth about 50% less.
Putting College First
In the last scenario, if the couple decided to focus on college first, investing the same amount each year in a 529 plan for the first 18 years, they could accumulate $253,000 by the time the child starts school.
In this case, they would defer saving for retirement until the child starts college.
This strategy provides the most for college, but potentially reduces their retirement savings by 70% compared with the all-retirement strategy.
Unless an investor has numerous other ways to pay for retirement, this strategy should probably not be considered.
A Balancing Act
There is, of course, no single strategy that will work best for every family.
As you evaluate your investing options, it’s important to keep in mind the effects of the trade-offs you make. It’s all a balancing act.
While it’s admirable to want what’s best for your children, don’t fall into the trap of becoming so obsessed with the goal of paying for college that you neglect your own retirement.
This article appeared in the April 2006 issue of the AAII Journal. The author, Christine Fahlund, was the senior financial planner at T. Rowe Price Associates.