Retirement or Education?

Chris writes in:

We are friends with another couple that is around our same age, income level, status, and number and age of children. When I was mentioning to them that we were planning to pay off our car this year (leaving us with our mortgage and a small student loan) and the starting to put $50 to $100 per into 529s for each of our kids (currently aged 1 and 3), she mentioned that they were not starting 529s, but rather had a different philosophy….. They were going to contribute up to the company match in the 401K, max out a roth IRA (every year) and then pay off their house in 15 years, which would be just when their oldest is about to start college. Then they would use any excess from their income (that was now free because they no longer had a mortgage) in order to help with their child’s education. She also mentioned that she did not believe that her children would qualify for much (if any) financial aid. This would be the case for us as well. We are currently putting approximately 10% into our 401K and we plan to put approximately $3,000 per ear into a Roth IRA starting this year. Can you comment on what might be the pros and cons of either financial philosophy? I suppose that I should also mention that I do not forsee us having any issues with having enough $ for retirement and my philosophy is that I would like to contribute to 25-33% of my children’s college costs.

First things first: with all things being equal, you’re better off putting your money into retirement savings than into college savings. There are several reasons for this.

First, your children can make college happen even if you don’t have a dime saved for them. Between student loans, scholarships, and other aid, most students who are accepted to a school will be able to find some way to go there. They may end up with a lot of student loans in the process, but it won’t prevent them from getting an education.

On the other hand, you can’t make up for missed retirement savings. Nothing can undo missing the early years of your retirement plan, because those are the years when compound interest is at its most powerful. The money you put away right now will be much more valuable than any money you put away in your 50s or 60s.

Another factor to consider is that many retirement plans allow you to “borrow” against them for educational expenses. You can withdraw some amount, agree to a repayment schedule, and use that withdrawn money to help pay for your children’s college education.

A final note: if you haven’t saved adequately for college, you may end up being a financial burden for your children late in life. You might not ever ask them for money, but they’ll see that you don’t have much money and will stretch their wallets to help you when they can. I have seen this many, many times.

In short, if you’re unsure, I recommend saving for your retirement over saving for your child’s education.

The next question, then, is why should one ever save for their children’s educational expenses?

We’re saving for that purpose. That’s because we have plenty of money to save at this point – our retirement savings are fully covered, plus we have extra money beyond that to push towards long term goals. One of those long term goals (for us) is to pay for some significant portion of our children’s college education. After doing the math, we decided that saving $100 per month for each child from the day they were born to the day they leave for college is the best bet.

In other words, if you can save for college without short-changing your retirement, go for it.

What about that third factor, though? Where does paying off your house rank?

When it comes to using your home as an asset for college savings, you’re betting on two things. First, you’re betting that the payments you make on your home mortgage are more financially efficient than money socked away in your 529. If your mortgage interest rate is 6%, then your money channeled into that is effectively earning a 6% return. If you put that amount in a 529 instead, you could earn more or less than 6%, depending on your investment choices and the risk you’re willing to take on.

The second (and more challenging) bet comes later, when you want to tap your home equity. You’re betting on the interest rates at that future date, because your loan will charge you some interest rate. Will you need the money at a time like today, where the Federal Reserve is keeping rates low? Or will you need it at a more challenging time, when interest rates are higher?

If saving for college is important to you and your family, I would probably do things in this order: retirement savings, then college savings, then mortgage.

One final note: I would never rely on future earnings to pay for college education. Our lives are far, far too uncertain to bank on your professional income in fifteen years as a source for college savings – or savings of any type. People radically change careers. People are downsized. People are disabled. People stumble into great opportunities. These things happen all the time. To bet on stability there would be the biggest gamble of all.

Good luck.

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