Tag: 529 plans

  • Investing for Retirement and Your Kid’s College

    Investing for Retirement and Your Kid’s College

    We recently talked about the tricky question of whether you should invest while you’re in debt.

    It’s a choice many people struggle with because we know debt can be bad and investing can be good.

    The desire to tackle both goals raises the question: should we focus on eliminating the bad thing or doing more of the good thing?

    In that post, we explored the four main reasons why I think it’s a good idea to invest while in debt. You can read more here.

    Today, we’ll talk about another challenging question that many of us face:

    Should we prioritize investing for retirement or investing for our children’s college?

    Like the question of whether to invest while in debt, this question presents a difficult choice because two things are true at once:

    Investing for retirement is a good thing.

    Helping our kids is a good thing.

    So, what should we do?

    This is a question I think about a lot now that I have three young kids.

    There are powerful emotional reasons on both sides of the question. And while money decisions are certainly emotional, using simple math can help you choose the right balance between retirement and college.

    Let’s start by looking at some of the emotional reasons and then explore how simple math can help us with this difficult choice.

    As a parent, I want to help my kids as much as I can.

    On the one hand, as a parent, I want to help my kids as much as I can. College is expensive and is only getting more expensive.

    I have personally felt the heavy burden of debt. It’s not a good feeling. If I can help my children avoid that feeling by paying for college, I will.

    I want to be free to retire on my terms.

    On the other hand, I want to be free to retire on my terms. To do so, I know that I need to start investing early and often. Just like college is expensive, retirement can also be very expensive.

    I don’t want to be in a position where I’m forced to work longer than I otherwise would because I don’t have enough saved up.

    If I skip out on investing for retirement to pay for college, I may end up in that situation.

    With powerful emotions on both sides of the question, is it possible to come up with a plan that helps accomplish both goals?

    Yes, I think we can. In this instance, it helps to remember that money decisions are both emotional and mathematical.

    Let’s revisit some of the math we’ve previously looked at to help us get closer to a decision.

    What does the math say about paying for college?

    We took a deep dive into saving for college in my post on using 529 plans for sky high college costs.

    While nobody can say for certain how much college will cost or how your investments will perform, you can make reasonable estimates and use an online calculator to help form your strategy.

    I like the calculator available on Illinois Bright Start 529 website. What’s nice about this website is you can look up the future estimated cost of attending specific schools around the country.

    I also like using calculator.net. They have a College Cost Calculator where you can see how much college costs on average today and how much it is estimated to cost when your child starts college.

    Whatever online calculator you use, you’ll have to make some assumptions when you start plugging in numbers, like an investment return rate.

    The S&P 500 has historically provided a 10% average annual return. So, 10% seems like a reasonable return rate to me for your estimations.

    Besides the estimated return rate, you’ll also need to account for the rising costs of college. Most of the online calculators recommend you assume the cost of college will increase by 5% each year. That also sounds reasonable to me.

    Graduation with woman with purple gown on because her parents saved for retirement and college.
    Photo by MD Duran on Unsplash

    With these assumptions in mind, let’s look at an example using a current kindergarten student.

    Since I live in the Chicago-area, we’ll assume in this example that the kindergarten student is going to the largest in-state college, the University of Illinois Urbana-Champaign (U of I).

    Illinois’ Bright Start 529 calculator estimates that the cost of a current kindergarten student attending U of I will be $264,735.

    Assuming you don’t have any current savings and you estimate a 10% annual rate of return, the Bright Start 529 calculator indicates you should save $10,796 per year.

    That comes out to $900 per month.

    By doing the math, you now have a reasonable estimate as to how much you should be saving for college.

    You do not have to rely exclusively on long-term savings to pay for college.

    If $900 per month seems like a lot of money, keep in mind that you don’t have to depend exclusively on these savings to pay for college.

    There are two key reasons for that:

    1. Your child can take out student loans.

    While it may not be your plan right now, don’t forget that your child always has the option of using student loans to help pay for college. Your child may also earn scholarships or qualify for other financial assistance.

    On top of that, there are hundreds of good colleges at varying price points around the globe. It is not the end of the world if your child ends up going to a lower-ranked but less expensive school.

    The bottom line is that there are options when it comes to paying for college. It is not exclusively up to your savings to ensure your child gets a good college education.

    In other words, don’t convince yourself that your student will be prohibited from attending college if you don’t save enough right now.

    2. You will likely still be earning income when your child starts school.

    Besides the availability of other options to pay for college, also keep in mind that you will likely still be working when your child starts school. There is no reason that you can’t use some of that income to help pay for school.

    If you continue to make intentional, solid money decisions, you should have extra funds available in your budget when your kid starts college.

    One way make sure that happens is to keep your expenses constant as your career progresses and you make more money. As an example, let’s say you bought a home while your kids were young. Of course, this is a common path for a lot of professionals who are starting a family.

    If you stay in that home long-term, your housing costs should be relatively fixed. As you earn more money, instead of upgrading your home, you can use that excess money to help pay for college.

    Once again, the point is that there are options to help your children pay for college even when your investments fall short.

    Now, let’s look at the math to figure out how much we should be saving for retirement.

    Just like we can use an online calculator to estimate the cost of college, we can also use a calculator to estimate how much we need to save for retirement.

    We took a detailed look at how to do this in my post on figuring out your magic retirement number.

    The key is to start with the 4% Rule,

    The 4% Rule suggests that you can safely withdraw 4% of your investments each year and expect your money to last for 30 years. 

    Without getting too technical, the 4% Rule is based off of research looking at historical investment gains, inflation, and other variables.

    For simplicity, let’s say you have $1 million in your portfolio. According to the 4% Rule, you can safely withdraw $40,000 per year (4% of your portfolio) and not run out of money for 30 years.

    Current Savings x 4% (.04) = Annual Retirement Spending

    $1,000,000 x .04 =$40,000.00

    The 4% Rule also works in reverse. 

    By that, I mean you can use the 4% Rule to ballpark how much money you’ll need in retirement to maintain your current lifestyle.

    Let’s say that you reviewed your Budget After Thinking and learned that you spend $6,000 per month in Now Money and $4,000 per month in Life Money. 

    Combined, that means your lifestyle costs you $10,000 per month, or $120,000 per year.

    To figure out how much you would need in investments to cover your current lifestyle for 30 years, divide $120,000 by .04.

    Current Spending / 4% (.04) = Magic Retirement Number

    $120,000 / .04 =$3,000,000.00.

    That means to maintain your current lifestyle of spending $120,000 per year for 30 years, you would need $3 million in investments.

    In other words, your magic retirement number is $3 million.

    Now that you know you will need $3 million in retirement, you can figure out how much you need to be investing today to hit that number.

    I like the calculator available on investor.gov for this part.

    With this calculator, you can plug in your investment goal, initial investment, years until retirement, and interest rate to figure out how much you need to save each month.

    Let’s continue our example assuming your magic retirement number is $3 million.

    We will also assume that you currently have $100,000 saved for retirement and you plan to retire in 30 years. We’ll also use the same 10% annual rate of return we used before.

    Based on these assumptions, you would need to save $635.82 each month to hit your magic retirement number of $3 million.

    With this information, you can now plan accordingly to make sure you are saving enough for retirement each month before you start worrying about college.

    woman on hammock near river relaxing because she invested for her future retirement while saving for college.
    Photo by Zach Betten on Unsplash

    Aim to hit your monthly retirement target before saving for college.

    By using these simple online calculators, you can estimate exactly how much you need to save for college and to save for retirement.

    I recommend that you aim to hit your monthly retirement target first before funding your college savings accounts.

    As we mentioned above, you and your child will have other options to help pay for college, like loans, scholarships, and concurrent income.

    By contrast, these options are not readily available to fund your retirement. You’re more-or-less on your to sustain yourself.

    Think about it: by definition, retirement means ceasing to work. That means no income coming in besides your retirement savings. There are not any loans (at least reasonable ones) or scholarships to bail you out in retirement.

    Sure, you could try to work part-time during retirement. But, that means you’re really only partially retired. Plus, it would be nice to have the choice to work in retirement because you want to work instead of being forced to do so.

    It’s for these reasons why you should prioritize saving for retirement over saving for college.

    In an ideal world, you can do both. If you control your expenses as your income grows, you give yourself the best chance to do both.

    How are you balancing investing for retirement with investing for college?

    While money decisions are certainly emotional, using simple math can help you choose the right balance between retirement and college.

    My recommendation is to prioritize retirement over college because of the additional options available to help pay for college. You’re essentially on your own when it comes to retirement.

    Once you’ve calculated your magic retirement number, you can then calculate exactly how much to save each month.

    When you can comfortably hit that number, you can then figure out how much to be saving for college.

    • Are you currently saving for retirement and for college?
    • How do you balance doing both?
    • Have you thought about other ways to help pay for college besides the options we discussed?

    Let us know in the comments below.

  • 529 Plans for Sky High College Costs

    529 Plans for Sky High College Costs

    My five-year-old has already decided that she’s not going to college.

    She doesn’t want to sleep there, she says. Instead, her plan is to move in with her aunt.

    At least that’s one kid I don’t have to worry about when it comes to paying for college.

    In case your five-year-old hasn’t already decided her future, read on to learn about 529 educational savings plans, one of the best ways to pay for college.

    My students are already worried about paying for college for their unborn children.

    Whenever I teach personal finance to law students, we take some time to at the beginning of class to discuss what each of us would do with financial freedom.

    This is always my favorite part of class.

    Over the years, I’ve had students who want to travel the world, start businesses, pursue hobbies, and take care of aging parents.

    I’ll never forget the student who wants to coach high school football after working as a lawyer. Or, the student who simply wants the time to exercise every day. As she put it, “look good, feel good.”

    Of all the goals I’ve heard, there is one that comes up more than any other: paying for their children’s education.

    A lot of times, I hear this goal from students who don’t even have kids yet. I think that shows how important education is for many people. It also shows how worrisome it is to think about paying for college.

    What’s troubling is that my students typically have their own student loans to pay back. And, before they’ve even started their careers, they’re thinking about paying for the education of their unborn children.

    That’s intense. But, understandable.

    Some students share that they want to pay for their children’s college because they benefitted from their parents paying for college. These students were grateful for the opportunities their parents gave them.

    For other students, they want to pay for their children’s college because their parents did not pay for their college. They want to help their children avoid student loan debt as they begin their careers.

    For most people, saving for college is a top priority.

    According to a recent study by Fidelity, 74% of parents say they are currently saving for college.

    77% of parents think that the value of a college education is worth the cost.

    At a time when there is a lot of uncertainty surrounding student loans, it’s never been more important to have a plan to pay for your kid’s education.

    One of the best ways to do that is with a 529 college savings plan.

    In today’s post, we’ll discuss the major advantages of 529 plans. We’ll also learn how you can estimate the cost of college for your child so you can figure out how much you should be saving today.

    Be warned, the numbers are scary.

    What is a 529 college savings plan?

    529 college savings plans are state-sponsored, tax-advantaged investment accounts. The name stems from Section 529 of the Internal Revenue Code.

    While there are certainly other ways to save for college, 529 plans are hard to beat.

    The reason 529 plans are such a great way to save for college is because you receive triple tax benefits:

    1. Most states offer tax breaks on contributions to its residents for participating in the in-state plan. For example, as Illinois residents, my wife and I can deduct up to $20,000 in contributions to the Illinois-sponsored 529 plan from our state income each year.
    2. Your investment earnings grow tax-deferred, meaning your investments will benefit from tax-free compound interest. That means your savings will grow faster without being hindered by taxes.
    3. Investment earnings are 100% free from both federal and state taxes when used for eligible education expenses. Eligible education expenses include things like tuition, room and board, books, computers and other standard costs associated with college.

    An investment opportunity with triple tax benefits like this is almost unheard of.

    How do 529 plans work?

    In basic terms, 529 plans are investment vehicles designed to grow your contributions and make paying for college easier. When you invest in a 529 plan, you are generally investing in some combination of stocks and bonds.

    That means there is risk involved, just like with any other investment.

    Once you open your 529 account, you will choose how to invest your contributions. In this sense, 529 plans are similar to a 401(k) plan offered by your employer.

    Like with your 401(k) at work, a 529 plan will typically provide you different investment choices within the plan. You can choose how aggressive or conservative you want to be with your investments.

    The investment options will vary depending on which state’s 529 plan you choose.

    Every state offers a 529 plan.

    Every state offers a 529 plan. You don’t have to be a resident of that state to use its plan. You also don’t have to use your 529 savings for a school located within that state.

    Regardless of what plan you choose, the federal tax incentive remains the same. Money invested in 529 plans grows tax free. That means no federal taxes on your 529 earnings as long as the money is used for qualified educational expenses.

    While you also won’t have to pay state tax on earnings (same as federal), there are some additional state tax implications to be aware of.

    These state tax benefits are a bit more complicated because they vary state-to-state.

    Blue USA map with borders of the states and names on grunge background illustrating that each state offers a different 529 college savings plan.

    Remember, there is no federal tax benefit when you make your original contributions. But, most states do offer its residents a tax break on their original contributions for investing in-state.

    Morningstar has a detailed breakdown of which states offer additional tax benefits to its own residents.

    If your state offers tax benefits to invest in-state, that’s usually a good reason to choose your in-state plan.

    My wife and I use Illinois’ 529 plan, called Bright Start 529, for the added tax benefits we receive as Illinois residents.

    Besides the state tax benefits, keep in mind that not all 529 plans are created equal. 529 plans may offer different investment options or charge different fees. States may also provide different level of oversight, which may be important to protect your investments.

    You should always do your homework before choosing a plan to find one that matches your goals.

    I’ve found Morningstar’s rankings and analysis of each state’s plan to be the most helpful tool. According to Morningstar’s most recent rankings, the top 529 plans are offered by:

    1. Alaska
    2. Illinois
    3. Massachusetts
    4. Pennsylvania
    5. Utah

    To recap, when choosing which 529 plan to participate in, pay attention to what investment options are available within that plan. Also, look to see if you will qualify for additional state tax benefits.

    How much can I contribute to a 529 plan?

    Besides choosing the type of investments in your 529 plan, you can also choose how and when to contribute.

    Some people prefer automatic monthly contributions. Others prefer to contribute sporadically throughout the year, like when they receive a bonus at work.

    Unlike with most retirement plans, there are no yearly contribution limits for 529 plans. Instead, each state sets lifetime contribution limits per beneficiary, typically ranging from $235,000 to $550,000.

    This is a good time to point out that you can have a separate account for each of your kids. This allows you to save more money overall sine the contribution limits apply separately to each kid.

    It’s also a good idea to have separate accounts when you have different investment horizons based on the ages of your kids.

    For a complete list of the contribution limits by state, click here.

    By the way, if those limits sound incredibly high to you, you may be in for a shock when it comes time to pay for college.

    Keep reading to see what the projected costs of attending college are for a current kindergarten student.

    What happens if my kid does not go to college or I have money left over?

    If you have money left over in your 529 plan, you have some options. You can use that money for one of your other kids, without penalty. You can save it for a grandchild.

    As of 2024, you can roll extra 529 funds into a Roth IRA for the beneficiary, with some limitations. This was a terrific development for families worried about having too much money saved for college.

    If none of the available options work for you, rest assured that your money will always still be your money. You will have to pay a penalty and some taxes. Any unused earnings are subject to a 10% federal tax penalty plus income tax.

    How much should I be saving in my 529 college savings account?

    This is the ultimate question, right?

    While nobody can say for certain how much college will cost or how your investments will perform, we can make reasonable estimates to help form your strategy using an online calculator.

    I like the calculator available on Illinois Bright Start 529 website. What’s nice about this website is you can look up the future estimated cost of attending specific schools around the country.

    I also like using calculator.net. They have a College Cost Calculator where you can see how much college costs on average today and how much it is estimated to cost when your child starts college.

    Whatever online calculator you use, you’ll have to make some assumptions when you start plugging in numbers.

    For example, nobody can predict what your exact investment return rate will be. That said, you still need to plug a number into the calculator.

    What number should you use for investment return rate?

    • Bankrate.com and NerdWallet each suggest using an investment return rate of 10% annually (before inflation) based on historical stock market performance.

    10% seems like a reasonable number to use, keeping in mind that we’re just looking for an estimate to help us decide how much to save for college. Your actual returns may be lower.

    Besides the estimated return rate, you’ll also need to account for the rising costs of college. Most of the online calculators recommend you assume the cost of college will increase by 5% each year. That also sounds reasonable to me.

    One last thing: it’s never a bad idea to run through different investment scenarios to get a more complete picture. Try playing around with what the numbers look like if your investments only return 8% per year. Or, see what happens if college costs increase by 6% per year.

    With these assumptions in mind, you can start to get an idea of how much you should be saving for college today.

    Be warned, the dollar amount will probably scare you.

    Let’s look at an example using a current kindergarten student.

    Illinois’ Bright Start 529 calculator estimates that the cost of this kindergarten student attending the University of Illinois Urbana-Champaign will be $264,735.

    Assuming you don’t have any current savings and you estimate a 10% annual rate of return, the Bright Start 529 calculator indicates you should save $10,796 per year.

    Does that sound like a lot of money?

    Want to really be scared?

    What if your kindergarten student is interested in private school for college? Maybe your child has his heart set on Northwestern University?

    Bright Start 529 estimates the cost of Northwestern University for your kindergarten student will be $691,942. That means if you have no current savings, you should be contributing $28,217 per year.

    Yikes.

    And that’s only for one kid.

    How are you supposed to save that much money for college?

    If these numbers sound scary to you, what can you do about it?

    I have some thoughts:

    1. First, you need to spend some time thinking and talking about why it’s important to you to be good with money. Maybe the reason is as simple as paying for your kids’ college. Whatever your money motivations are, write them down. This is what I did with my Tiara Goals for Financial Freedom.
    2. With the right motivation in mind, you then need to make a Budget After Thinking. The overall purpose of your budget is to generate fuel for your future goals, including paying for college.
    3. Next, you need to stick to that budget by tracking two simple numbers. Making a budget does you no good if you aren’t sticking to it.
    4. Monitor your savings rate and aim for steady improvement over time, even if you’re only able to save a small amount to begin with.
    5. While you start to build your savings for college, avoid the three big causes for why many of us fall into debt, which can cancel out all your progress.
    6. Along the way, talk to your people. Remember the cardinal rule of Think and Talk Money: talking about money is not taboo. You are not alone in trying to save for college or trying to live a financially responsible life. Talking to your people will help you stay on track when times seem tough.

    The most important thing is that you take responsibility for your own money life.

    Nobody else can do this for you.

    The good news is that embracing these tips will help you beyond just paying for college. These are the exact strategies that will lead you to a life of financial freedom, the ultimate goal for many of us.

    It’s not supposed to be easy. If it were easy, everybody we do it.

    By educating yourself on 529 plans and talking to your people about money, you are way ahead of the curve.

    Do you have a plan to save for college?

    • Have you started saving for college?
    • Are you currently using a 529 college savings plan?
    • How do you motivate yourself to make regular contributions in light of other financial goals?

    Let us know in the comments below!