David LaRocca, JD, CFP®
Private Wealth Manager
A question on many of our clients’ minds is whether they are saving enough for retirement and their children’s education. For clients in the asset accumulation phase of life with young children, there are often competing demands on their cash flow, which makes it difficult to adequately save for both retirement and education. Oftentimes, clients must decide whether to prioritize saving for retirement or education.
Faced with this choice, many parents ultimately choose education savings. In fact, a recent survey from T. Rowe Price revealed that almost three quarters of parents with younger children prioritize education savings over retirement savings. The same dilemma also applies for parents with adult children: another study from Merrill Lynch and Age Wave indicates that parents spend twice as much annually on their adult children as they spend on retirement savings. Much of this spending is for their adult children’s college education.
While saving for a child’s education is an important goal, it more often makes sense for parents to prioritize retirement savings over education savings, all else being equal. On the surface, this may appear selfish – why would parents prioritize having a comfortable retirement over their children’s education? However, prioritizing retirement savings makes good financial sense in many cases, and it may ultimately benefit the children in the long run. Let’s look at why.
Funding even a moderate retirement lifestyle is more challenging and requires more resources than paying for education.
First, a four-decade retirement is obviously more expensive than a four-year college tuition bill, and people thus should begin saving for retirement as soon as possible. In earlier periods, when parents tended to have children earlier in life, there was more time to save for retirement after the kids were off the family payroll. However, with people waiting longer to have children, retirement can follow soon after the last tuition bill is paid, leaving much less time to focus solely on saving for retirement.
Second, there are more ways to pay for education than retirement. In addition to education savings, such as savings from a 529 plan account, there are student and parent loans, scholarships, and grants. A student can also get a part-time job or get additional support from a grandparent or other family member. The ways to pay for retirement are more limited. For most retirees, especially those in Generation X and younger, there are no guaranteed pensions or golden parachutes, so retirees generally are limited to retirement accounts and whatever they get from Social Security to fund their retirement.
Third, planning for the cost of education is easier than trying to estimate the cost of retirement. College costs are increasing – by some estimates, as much as 6% per year in the past two decades. However, they are finite and relatively estimable. Retirement costs are a lot less predictable, especially with increasing life expectancies. Putting aside the quality of life a retiree may ultimately want to have, there are many factors out of a retiree’s control that impact retirement spending. Will I live to 100 or die relatively young? Will my spouse or I have significant medical costs or require long term care? Will I retire during a long market correction that prematurely depletes my assets? To account for these unknowns, a buffer is needed around a retiree’s expected income needs, necessitating that more funds be devoted to retirement.
Finally, the implications of an underfunded retirement are more severe than an underfunded education. As a last resort, a student can temporarily postpone his or her education or transfer to a lower cost school. Neither of these options are ideal, but they are not life threatening. A retiree who is running out of money will have to choose from more unappealing options, including going back to work, cutting back on their lifestyle, or devoting a significant percentage of their income to medical costs.
The different types of savings vehicles generally favor retirement savings over education savings.
Federal and state tax laws incentivize saving for retirement and education, but they do so differently and tend to favor retirement savings over education. For example, in 2019, the IRS will allow pre-tax contributions of up to $13,000 in a SIMPLE IRA, up to $19,000 in a 401(k), and up to $56,000 in a SEP IRA, and in some situations employer contributions and catch-up contributions can increase these amounts. The assets then grow tax deferred and required minimum distributions do not begin until the accountholder reaches age 70.5. This is a significant tax break the government gives to taxpayers and clearly encourages saving for retirement.
Alternatively, the most common type of education savings vehicle is a 529 plan account. The federal government does not offer any tax breaks for 529 plan contributions and most states offer minimal, if any, tax breaks for contributions. 529 plan withdrawals are tax free if used for certain education expenses, but the growth period generally is shorter than retirement savings (18-22 years versus several decades) and taxes and a penalty of 10% apply to earnings that are withdrawn for a nonqualified purpose. For this reason, we typically recommend that clients put away no more than 70% of their education savings in a 529 plan account.
Further, retirement accounts generally offer more investment choices than 529 savings plans. While 401(k) plans often have limited investment selections, IRAs offer far more investment options than the typical state 529 plan. There also are several different type of retirement accounts (Roth IRAs, SEP IRAs, SIMPLE IRAs, 401(k)s, etc.) so an investor can choose the type of account that best suits that person’s financial situation. Other than a Coverdell Education Savings Account (which has a $2,000 annual contribution limit), a 529 plan account is the only tax-favored savings vehicle solely devoted to education.
By prioritizing retirement savings, a parent may help a child more than by saving for education.
It may seem counterintuitive, but prioritizing retirement saving over education saving may be more beneficial for the child as well. The main reason is that parents who fail to adequately save for retirement may become a financial burden on their children in later years: a survey from the Pew Research Center found that parents of the household head make up 14% of the adults living in someone else’s house, as opposed to 7% in the mid-1990s.
Additionally, assets in a retirement account will have a longer period to grow than assets in an education account. Due to the powerful impact of compounding interest over time, a child may ultimately inherit more money from a parent’s retirement account than he or she would have received if the parent had devoted the funds to college savings.
Finally, as a last resort a parent can withdraw money from a retirement account to pay for education. Although it’s often not advisable, money in a traditional IRA can be withdrawn to fund a child’s higher education expenses without a 10% penalty even if the accountholder is younger than 59.5, and a parent also could take a loan from a 401(k) account to fund a child’s education.
At Creative Planning, we help clients work though these issues and construct a customized retirement and education savings plan that is best for them.
While prioritizing retirement savings over education savings may make sense theoretically, there are many factors that influence the decision on how to allocate limited resources. In some situations, parents may temporarily devote more funds to education savings if a child is close to college, or they may be able to reduce their retirement savings if they expect a substantial inheritance.
At Creative Planning, we recognize that every client is different. We work with our clients to create a customized financial and investment plan that is best for their individual circumstances. This includes helping clients make decisions about saving for retirement, paying for a child’s education, and a variety of other financial matters.
At the end of the day, we are a family office. So, our goal is to help our clients save for a comfortable retirement and help their children get a good start in life through a college education.
This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.