How Much Should I Save for College?
Topics: 529 plans, 1/3 Rule, Cash out refinancing, 1031 Exchange, College expense calculator
In my last blog I asked the question: How Much Money Do I Need to Save for Retirement?
Speaking of saving, there are lots of reasons to save – while your retirement should be at the top, you may also be considering saving for college. While this is certainly a post about college savings, as you will soon read, I manage to tie-in some real estate topics. College planning is an opportunity to help the next generation in their long-term Financial and Asset Management. Perhaps the desire to support your kids stems from toiling through college and emerging with student debt. Or maybe that’s the reason you aren’t saving for college. No doubt there are valuable lessons to be learned from funding college yourself and the hard work and time management that requires. Certainly, there is a sense of pride in the investment you made in yourself. As you contemplate funding college for your loved ones, I would encourage you to make sure retirement goals are on track and your savings rate is adequate before you consider funding your child’s college education. Though it’s not ideal to start your professional career with a mountain of student loan debt, your child has his or her entire working career to pay it off. If you are mid-way in your career or closer to retirement, then I suggest you avoid accumulating additional debt to make life easier for your child and focus on your retirement. If you have questions about your retirement goals or savings rate, send me an email: email@example.com. Or click here to start a conversation about college savings or if you’re curious about your net worth.
On a personal note
When our oldest child was about two and our middle child was brand new, we opened some 529 college savings plans for them. We set up automatic monthly payments so not contributing wasn’t an option (or it was at least a little more difficult). It wasn’t until a few years later (with child #3) that we started doing the math to better understand what we were facing – SHOCK! College is expensive! While that didn’t immediately impact our savings plan, it was good to know we may have to pick up a little slack as we get closer to college (and maybe pay up for those ACT/SAT study programs!).
On the other hand, while we prefer not to have to use debt for our children’s academic funding, student loans aren’t the worst thing in the world. Our own pursuit of additional education led to about $75,000 in student loan debt. Fortunately, at least one of us was always working during the extended education period, and I finished my program about a year before my wife started. While going back to school was absolutely the right choice and using student loans was the only way to accomplish this, I hated the monthly payments. But with a low interest rate (and the ability to make payments over the next 20 years), it was more important to move forward with buying our first home (and then also our next home), as well as funding retirement and start saving for the education of the next generation. But we did accelerate our student loan payments and about 7 years after my wife walked across the stage, we were free of our student loan debt.
Ok enough personal stuff.
How much does college cost?
Well I mentioned my shock about the cost of college – today it could easily cost $100,000 or more to send your child to the local public university (in-state) - so easily $25,000 per year. Out of state tuition can be closer to $40,000! Cost for attending a private university could easily be $70,000 per year or more. While that’s not great, the problem for those of us with younger kids is that college tuition costs historically rise at a faster clip than inflation. A recent report noted costs for a 4-year degree on average doubled, even after adjusting for inflation from the 25-year period from 1989-2016. I’m not an economist, but I don’t think the dollars in my wallet right now are adjusted for inflation. So my translation is that college costs increased by 4 times in 25 years (doubling in 12.5 years and then doubling in another 12.5 years) considering numbers not adjusted for inflation. So basically if historical standards hold, the college education of today’s kindergartner can easily cost twice as much as it does now - especially since the value of today's dollars continues to rapidly decline.
So how do we plan for that?
Well the good news is it’s unlikely you will need to raise 100% of the funding required for college. A rule of thumb I’ve seen used (for large purchases) is the 1/3 rule – use savings, current income (or in this case scholarships, etc.) and loans in the same proportions. I’d prefer to eliminate debt from the equation or at least minimize it, so I’m targeting a higher number than the 1/3 rule would suggest. The benefit of saving too much in your child’s 529 is that anyone related to the beneficiary can use the funds from that account. Even you! Or your next child. Or they can use it for graduate school, or medical school! Also of note, in addition to scholarships, opportunities for concurrent enrollment or testing out of basic required classes can also help reduce the burden as long as students are able. In addition to those tuition-saving ideas, getting through college faster (say 4 years or less) would save potentially a year’s worth of living expenses.
So how do we start saving?
My preference is the 529 college savings plan. After paying taxes, you deposit funds in these accounts and your investments grow tax-deferred. As long as the funds are used for education expenses, you don’t pay taxes. This is pretty simple, as most 529 plans have age-based investments that automatically adjust to take on less risk as your child gets closer to college age. The curveball is that states with no state income tax (like in Texas where I live now) can’t offer any tax incentives similar to states with state income tax. But then you are free to choose any broker’s 529 plan. If you do pay state income tax, you might be eligible for a tax benefit if you invest in your state’s plan. Your CPA can help understand that better. I don’t charge fees for management of client 529s in my Asset Management program. Mostly because its so simple – open the account, set up automatic payments in a low-cost age-based fund. Vanguard and Fidelity have great low-cost options. If you’ve read anything I’ve written or looked at my website, you know I’m all about keeping costs down and saving money for the long-term.
While there are other strategies to fund the expense of college, none are any that I would propose to a client and thus I won’t discuss them here. However, since I love real estate I thought I would address the idea behind using it to fund college.
Should I use real estate to fund college?
This is a very interesting idea. I say no because there are better options. At least not if you aren’t already a real estate investor. Buying a single property to cover a child’s college expenses doesn’t make much sense to me – here is my logic:
There are different risks and tax implications and the 529 is so easy. While I love real estate, I want to keep it for long-term wealth. But for argument’s sake: The idea is let’s say a parent has a three-year-old. They purchase an investment property under a 15-year mortgage that would be paid for when the child is ready for college. With the higher payments of a 15-year mortgage, you would likely be contributing a few hundred dollars a month since the rent would not cover all your expenses (in most cases – side note: if you can find cash flow from a 15-year mortgage, you should jump all over it since finding suitable returns using the lower payment of a 30-year mortgage is getting more difficult).
Risks and Cash-Out Refi
The risk is that you have a single asset in a single market vs the diversified assets in a 529. You are choosing one particular point in time to make this purchase and generally one point in time 15 years later when you likely have a big decision (refinance or sell). Contributing to a 529 allows for dollar cost averaging over a significantly long period with less risk toward the time when you will need cash. The risk with real estate is that decision at Year 15 – refinance and pull cash out or sell (more on selling later). Refinancing will allow you to pull out a lump sum of cash but then you have to find the best spot for that cash short-term. With a 529 you can pull out cash at different increments (when your tuition payments are due) AND you can continue your contributions through the college years – so greater flexibility and better cash management. If you do nothing at Year 15, you can use monthly cash flow from your property for tuition payments, but those don’t exactly line up. Also with a refinance you then are taking on additional debt and have to want to continue being a landlord – if that’s part of your financial plan and you don’t mind the debt, maybe that’s not an issue.
As for tax implications, if you sell your property to fund your child’s college tuition, you will pay capital gains tax unless you lived in the property for two of the last five years or you do a 1031 exchange. In an exchange scenario, you have to again be a landlord, but now for a different property, and you have a short window to identify (45 days) and close the deal on this new property (180 days). This new property will require a larger purchase price and the same or higher loan value than the property you just sold, meaning not all the dollars you saved can be dedicated to college. And eventually you will pay taxes. Or die. I’ve not done a 1031 exchange but hope to one day, and let my heirs deal with the taxes.
So in summary, keep your college planning simple. Use a 529 at a reputable broker unless the tax benefits you get from your state are meaningful. Keep your costs low, your investment plan simple and your contributions regular. You will unlikely be required to fund the entire bill, but without student loans, I suggest aiming for well more than half – maybe even 80-90%. If my eight-year old’s college bill is going to be in excess of $200,000, I’d like to get pretty close to that. I don’t want my lack of savings to be the limiting factor in my child’s future. I can’t tell you what the right number is for each scenario (unless you are an Asset Management client or allow me to create your Financial Plan), but hopefully you understand the process and this gives you an idea to set your expectations. And as you consider your monthly contributions, Vanguard has a great, easy-to use calculator that can adjust the necessary variables and they have other good resources as well.
If you or someone you know has any financial-related questions, I would love to have a conversation, so please feel free to reach out: firstname.lastname@example.org
And please don’t forget to view our prior blogs:
And stay tuned for additional blog posts on retirement savings and other topics.
Best wishes on your financial path!
This post was created by Matt Beeby, the Founder of MHB Advisory Services. Matt has been working in Financial Services and investing in real estate since 2005, though his investment experience spans nearly two decades. He is a Christ follower, active in both his church and his neighborhood association. Matt enjoys sports and family time. Read more about Matt on his website bio.
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