Many college graduates receive more than a degree – they also leave school with thousands of dollars’ worth of debt.
For parents, this presents a dilemma: Do you find the money now to help pay college costs, or is it actually better to help your children later, when you’ve had a chance to save money in your 401(k) or other retirement fund?
It may seem counterintuitive, but allowing your children to assume loans could benefit both of you. Most importantly, it will allow you to accumulate savings over a longer period and adequately fund your retirement, securing a better financial future for both you and your children.
Here’s why: Young people have a lifetime ahead of them to earn a living, pay off debt, and save for retirement. Adults with college-age children, on the other hand, don’t have much time left to fund their golden years. Parents with good incomes who can pay for college outright should still opt to save for retirement first, especially if funding tuition requires putting a halt to other savings, for example, to their 401(k), 529 (for younger child), SEP, 403(b), or other tax-favored accounts.
Consider a hypothetical scenario of a New Jersey couple with two children. Husband and wife will both be 50 years old when their elder child starts college. The younger child will start college right after the older one graduates, so the couple will have a total of eight consecutive years of tuition.
Let’s also assume that both parents want to retire at age 65 and will live 20 years after that. Assume annual tuition cost, plus expenses, of $27,000 (without inflation) per year, or $216,000 for all eight years.
If our couple chooses not to pay for college, they are then able to each contribute $16,500 to their 401(k)s or other tax-deferred savings accounts, as allowed by the Internal Revenue Service. If they are age 50 or older, they are each also allowed an annual “catch-up” contribution of $5,500. When you add a typical 3% employer match as a couple, they will save a total of $45,320 annually.
Illustration – If the parents contribute nothing to their 401(k)s from ages 50 through 57, but resume the maximum level of contributions at age 58, they will have forgone $1.054 million in savings, company match, and investment income. Assuming a 6% after-tax rate of return, their annual draw will only amount to $37,000 vs. $131,000 for the same 20 years if they had never stopped saving.
Assume this couple borrows the money needed for education at a current interest rate of 5% for roughly a total loan expense of $275,000, including interest. To pay back this loan, the family would incur approximately $3500 per year for each year of tuition borrowed, or for each $27,000 borrowed. Loan payments are usually due over a ten-year period. Hence in a “worst-case-scenario” loan, you need to start paying the loan back immediately. Initially this will cost you about $3,500 in year one and $7,000 in year two, etc. Once children are out of college they can help shoulder all or part of the responsibility.
As you can see, paying for college before saving for retirement can be costly in more ways than one—you could be sacrificing a financially secure future for you, which may also mean your future ability to help your children.
If your child’s education is 100% financed—even if you help pay off those loans while the children are still in school—you will be better able to sustain your lifestyle today as well as tomorrow.
Janet L. Critchley, CPA, PFS, MST is a financial analyst for Brinton Eaton(www.brintoneaton.com) a wealth advisory firm in Madison, N.J., serving individuals and institutions throughout the U.S. She can be reached at email@example.com.