College is expensive – everyone knows this. According to a 2019 study from Sallie Mae, the national average cost of public school is about $20,000/year and the national average cost of private school is about $48,000/year. Here in the Northeast – those costs are much higher. UMASS Amherst (a public school) currently costs $29,000/year for an in-state student and $48,000/year for an out-of-state student. Boston University (a private school) is now $70,000/year for all students!
This is one of the most common questions that I hear from parents. How much should we be saving for our children’s education? The answer is not black and white. It really differs for everybody based upon your income, your values and your educational background.
Here is a helpful framework that I guide parents through –
- Would you like to pay for public or private school?
- What is the opportunity cost of the money you are saving for education?
- Is a 529 plan really the best vehicle for you to start saving in?
Would you like to pay for public or private school?
This is an important discussion for parents to have and it often ties back to their own experiences. One parent might have gone to public school and one parent might have gone to private school. It’s helpful for parents to reflect back on their college experiences and ask how that experience helped get them to where they are today.
Was it the possible superior education curriculum at a private school? Or was it how you personally spent your time when you were there?
When hiring people, I found myself most intrigued by the students who showed a dedicated interest to a specific industry, spent their time getting involved with clubs/organizations and networked with industry professionals. While their educational background was important, I believe what you do is more important than where you do it.
For parents, the public vs. private school discussion is so important because it dramatically changes how much you save for education.
Let’s say a married couple lives in Massachusetts and has 3 kids – ages 5, 3 and 1. They earn a combined income of $250,000/year and want to know how much they should start saving for their children’s education.
If they want to save enough for their children to fully fund the cost to attend UMASS Amherst (public) for 4 years, they would need to save:
- 5 year old = $9,290/year
- 3 year old = $8,375/year
- 1 year old = $7,420/year
- Total savings required = $25,085/year
If they want to save enough for their children to fully fund the cost to attend Boston University (private), they would need to save:
- 5 year old = $23,214/year
- 3 year old = $20,216/year
- 1 year old = $17,910/year
- Total savings = $61,340/year
In order to fully fund private school for their three children, it would require an additional $36,255/year compared to fully funding public school. Since you are saving with after-tax dollars, this equates to roughly $50,000/year of income. This forms an important basis for the next question – what is the opportunity cost of that money?
What is the opportunity cost of the money you are saving for education?
This is the question that is not discussed enough. Not only should you consider the opportunity cost of saving for public vs. private school, but also the opportunity cost of saving money at all for your children’s education.
The most impactful years of your children’s life are before the age of 10. In fact, 90% of the brain’s capacity has already developed by the age of five. A child’s brain is more receptive to learning during those years compared to any other time in their life. Your children start forming their personality, values and passions.
One of the most consistent values I hear from parents is to be present and involved with their children’s lives. Money can’t replace childhood and too often, parents are not as involved in their children’s life because they are working so hard to pay for that expensive future education cost. You can always borrow money or go to a lower cost school in the future, but you can’t make up for lost time during their childhood.
What opportunities would open up if you did not save for your children’s education during the first 10 years of their lives? Here are some ideas:
- Scale back work and earn less income so you can be more present with your children.
- Pay for advanced education when your kids are young and rapidly developing their brain’s capacity.
- Travel with your children and share meaningful experiences with them.
If you are able to be present with your children, share meaningful experiences with them and save for education, that’s great! However, if you are unable to do all three, you should carefully weigh which one you are giving up. People often sacrifice the one that can’t be replaced in order to pay for future education costs.
I’m not saying you shouldn’t save for education at all, but rather, don’t let the cost of education in the future dictate how you spend your time, especially during the early years of your children’s lives.
Is a 529 plan really the best vehicle for you to start saving in?
If you feel confident you are ready to start saving and know what your education funding target is, the next question is how should you be saving?
The most common way is a 529 plan. This is an account that is specifically earmarked for education costs and provides the benefit of tax-free growth of investment earnings if the funds are used for qualified education costs. Some, but not all, states offer tax deductions for contributions, but I will focus on the tax-free growth benefit of 529s.
What happens if your child receives a full scholarship or decides not to go to college? You do have the option of transferring the 529 funds to another child, but then what happens if you “over save” and have funds remaining in a 529 plan once all of your children are done with school? If you withdraw funds from a 529 plan and those funds are not used for higher education expenses, then you pay tax and a 10% penalty on the investment earnings (not contributions). This is why I’m not a huge fan of 529 plans – they lack flexibility.
Let’s use the prior example of saving $23,214/year for the 5 year old to attend Boston University in the future. Let’s say you could either save the $23,214/year in a taxable investment account or a 529 account. For simplicity sake, we assume that they both grow to the same amount when the 5 year old turns 18. This amount would be about $436,000.
Now you either have $436,000 in a 529 account or $436,000 in a taxable account. The total annual contributions would be $301,782. which means the investment earnings are $436,000 – $301,782 = $134,218. The benefit of the 529 plan is that this $134,218 of earnings is tax-free when the funds are used for qualified education expenses.
If instead, you liquidated the investment account to pay for education costs, you would pay $134,218 * 20.2% (15% assumed federal capital gain tax rate + 5.2% MA capital gain tax rate) = $27,112 in tax. This seems like a lot, but that is a tax you would pay in 13 years. The present value of this $27,112 tax is $14,378 in today’s dollars.
If, however, you don’t need the 529 funds in the future and you withdraw the funds, you would pay the $27,112 of tax plus a 10% penalty of the investment earnings. This equates to $27,112 + (10% * $134,218) = $40,533, or $21,496 in today’s dollars.
As with everything, how you frame the conversation is so important. This is what it boils down to –
- Would you rather lock money up in a 529 plan in order to avoid paying the equivalent of a $14,378 tax today, with the possible risk of paying a $21,496 tax & penalty today if you don’t use the 529 funds for college; or
- Would you prefer to provide yourself with more flexibility to use the funds in any way and possibly pay the equivalent of a $14,378 tax today to fund education in the future?
Money in a taxable account can be used for any reason – home renovation, travel, long-term financial security, etc. However, money in a 529 account can only be used for qualified education expenses.
With so many uncertainties in the future, this helps form the basis for a valuable conversation to have before you start putting money away for education.
Key takeaways
- Don’t automatically assume you should start saving for education. Kids are expensive and it often makes sense for parents to maintain financial flexibility, something I recently spoke with Business Insider about.
- Ask yourself 3 questions before making any decisions.
- Would you like to pay for public or private school?
- What is the opportunity cost of the money you are saving for education?
- Is a 529 plan really the best vehicle for you to start saving in?
- Think about the experiences that may be more meaningful than paying for college. Having present parents, that educational trip to Europe, or the consistent family vacations may have a greater impact on your children’s development than helping cover the cost of college in the future.
- Be open and honest with your children about what you saved for and why. If you decided to save enough for public school, educate them on why. If you decided to save enough for private school, educate them on why.
Assumptions and sources used
- Tuition costs increase 3% each year
- Assumed investment returns are 5%
- College Tuition Compare
- Sallie Mae 2019 College Study
Disclosures
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