Balancing Retirement and College Savings

In a recent talk, college funding expert and financial planner Ann Garcia suggested a rule of thumb for balancing retirement savings and college savings. Her rule had two parts:

If you're not saving anything for retirement, don't save anything for college. If you're not maxing out your retirement accounts, only 10% of your savings should go toward college.

When I first heard this rule, I thought, “That's clever, I should do a post on that.” However, after thinking about it for a week or two, I don't think it's a very useful rule.

Retirement Savings Is More Important Than College Savings

One thing I love about the rule is that it emphasizes the importance of saving for retirement over saving for college. Too many people—probably because college usually hits before retirement and because people “would do anything to help their kids succeed”—put money that should be going toward their own retirement toward their childrens' college savings instead. That's a huge mistake for several reasons.

First, your kid can get a loan for college, but you can't get a loan for retirement. Even better, you and your kid can simply elect to spend less on college. I mean, college pretty much costs what you are willing to pay. Your child WILL get a college education. Maybe it won't be at the “dream school,” but they'll certainly have the chance to go somewhere. Most of the time, it really won't matter all that much where they go.

Second, you need a whole lot more money to retire than to pay for college. Perhaps you need $100,000 for college. But you may need 20 or 30 times that to retire. That means you'll need to save a lot more money for a lot more time to reach that goal. You need to get started early, stay on task, and save a large amount of money every year for your entire career. While the exact amount depends on your individual goals, a good rule of thumb for physicians, dentists, and other high-income professionals with a relatively late start to their careers is to save 20% of gross income for retirement. You don't need to save anywhere near that much for college.

Let's say you want to save up $100,000 in today's dollars over 10 years for college. How much do you need to put away?

=PMT(5%,10,0,100000) = $7,950 per year

For a physician earning $300,000, that's less than 3% of gross income. Even if you have three kids, that's still less than half of what you need to save for retirement.

Third, you can best help others from a position of strength. Let's say your kid gets into their dream school and you want to help them pay for it but you didn't save a thing for college. What other options do you have? The best one is to simply cash flow part or all of the cost of college. You're a doctor, remember? You make $200,000 a year or more. Your household might even make more than $400,000. Surely some of that income can be used to cash flow college costs.

Where will the money come from? You could spend less or work more, but even if you're not willing to do that, you could use some of the money you would have been putting toward retirement and use it to cash flow college costs. Now you're in a position of strength, and you have options. But if you've done the opposite and put all your money toward college thinking that your kid will go to Yale and then they don't go to school at all, now you're stuck paying taxes and penalties on 529 withdrawals to pay for your retirement. That's much worse.

Fourth, lots of retirement savings can be repurposed for college. A taxable investing account can be used for anything you want. Roth IRA principal can be withdrawn at any time tax- and penalty-free. All Roth and tax-deferred IRA and 401(k) money can be withdrawn for qualified higher education expenses at any time penalty-free (and tax-free in the case of Roth accounts). In essence, a Roth retirement account IS a poor man's 529. The only people who should use a 529 are those who have already maxed out their retirement accounts.

More information here:

4 Pillars for High-Income Families Paying for College

How Much Should You Sacrifice to Pay for Your Child’s Medical School Education?

How Much You Should Save for College

So, if that rule of thumb is not useful, what should you do? The purist's answer is to calculate how much you need to save for retirement, save that, then calculate how much you need to save for college, and save that. This requires the use of a financial calculator or spreadsheet, and it's something we teach in our Fire Your Financial Advisor online course. It's really just the “Payment” function on a spreadsheet. Let's say you want to spend $100,000 a year in today's dollars, so you use the 4% rule to calculate that you need a nest egg of $2.5 million. You plan to work for 22 years to get to that $2.5 million. We'll use a rate of return of 5% to reflect a “real” (after-inflation) return. The function looks like this:

=PMT(5%,22,0,2500000) = $64,926 per year

If you can't save that much, well, everything you can save should go toward retirement. If you can save that much, great! If you can save more than that, the additional savings can go toward college. But how do you know when you are saving enough for college? First, you need to estimate, calculate, or simply specify how much you are going to provide for college. For simplicity's sake, this is often just a lump sum to have when your kid graduates from high school. Let's say that amount is $150,000. If the kid is 6 years old, that leaves you 12 years. Again, we can use the 5% real rate of return.

=PMT(5%,12,0,150000) = $9,424

If you already have something saved for college, you simply replace the 0 in the equation above with the amount you have (as a negative number). If you already have $50,00o saved, it looks like this:

=PMT(5%,12,-50000,150000) = $3,783

Why use a rule of thumb (that will often be wrong) when doing an actual calculation is so easy?

But what if your assumptions change? Fine, change the calculation and how much you save then. Like everything else in life, you adjust as you go.

What do you think? How do you balance saving for retirement and for college? How much did you put toward each last year?

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