A college education is a significant financial decision that can greatly impact the lives of individuals and their children. It has long been regarded as the key to a successful future, but the rising costs associated with higher education necessitate careful financial planning. In this article, we will explore the inflationary costs of college, the potential expenses involved, and various savings options for parents to consider.
The Inflationary Costs of College Education:
Higher education costs have been rising at a faster rate than the general economy. To account for this, we tend to lean towards a 5% inflation rate rather than the broader 2-3% inflation rate of the overall economy.
The University of Michigan currently costs about $16,736 per year for tuition and roughly $13,170 for room and board. This puts the current total per year cost at about $29,906, and assuming a 4-year degree, the total cost of college may be around $119,624. It is important to note that not every student will choose to live in the dorms every year, and off-campus housing is usually more affordable. Some students may also decide to attend a community college or decide to live at home for a couple of years. Also, many students are taking a fifth year to finish their degree, so these estimates can certainly fluctuate per student.
Saving for College:
Parents often begin considering college savings after their child is born, leaving them with approximately 18 years to accumulate funds. We take the assumed 5% inflation rate and apply this for 18 years, then the total cost of an education at the University of Michigan might end up costing roughly $287,889. This is a huge expense that some parents might not be prepared for, and this could be a detrimental burden if the student takes the full amount in student loans.
If we assume all the college savings were put into a savings account at the bank that earned a negligible amount of interest, then the parents would need to save about $16,000 per year for 18 years to hit this goal. However, there are other options available that offer more growth potential, but more growth tends to include more risk. This means that if the savings were invested, then there is a chance the accounts could lose money. This concept stresses the importance of understanding the sequence of returns risk. For more details on this topic, refer to our article on Sequence of Returns Risk.
If we assume a modest 6% rate of return, then the savings could outpace the college inflation rate by 1% per year, which makes quite the difference over 18 years. This rate of return would only require about $9,315 per year to be saved. The remaining amount would be realized as part of the 6% growth to hit the desired level of college savings. As always, starting to save earlier is always a better idea to realize more compounding growth.
College Savings Programs:
A few different college savings programs can be utilized, including the most well-known option: 529 Plans. A 529 college savings plan allows parents to receive up to a $10,000 Michigan state tax deduction for contributions, the funds will grow tax-deferred within the account, and withdrawals for education are made tax-free. However, withdrawals for non-education expenses will incur a 10% penalty on top of the income taxes that will be due. So, these accounts are great for education savings but not great for flexibility. 529s will begin to allow a limited Roth IRA conversion starting in 2024, so a portion of the funds can be converted to retirement savings for the beneficiary.
Or the beneficiary can be updated, and the funds can be used for somebody else’s education expenses. 529 or other college savings plans are obviously geared towards setting aside funds for future education expenses. That is where these accounts shine the most, but they will lack flexibility for other types of expenses.
Considering Non-Qualified Flexibility:
We are beginning to see a decline in demand for a college education as employers are becoming more focused on acquired skills rather than a formal diploma. So, what happens if your child does not go to school? Well, the options would depend on how the funds were saved. The most flexible type of account would simply be a non-qualified brokerage account. The performance would depend on the underlying investment within the account, similar to a college savings plan, but more investment options are usually available within the brokerage account.
The parents would remain fully in control of the assets, but they would also be responsible for any capital gains taxes incurred from the investments. However, these savings would be available in case of a drastic emergency or a change of plans for your financial future. It is important for parents to assess their child’s likelihood of going to college and to create a plan that balances college tax savings with non-qualified flexibility.
Balancing Retirement and College Savings:
Lastly, we want to leave you with a figure of speech we often use with our clients making college savings decisions. As illustrated by the cost of college above, saving for education can have a huge impact and possibly even delay your retirement plan. What if these assets were the make-or-break amount needed to retire on time? Parents are often forced to make this difficult decision. Is it more important to save for your retirement or save for your child’s college education?
Just like they recommend on an aircraft, we recommend securing your own oxygen mask first before assisting others. Or in financial terms, we recommend securing your financial future before assisting others. This can be a tough concept for parents to grasp, and rightfully so, but that is why your personal advisor is there to assist with the decision-making.
College Funding Highlights
- College is becoming a less popular career route, so gauging whether your children will pursue a higher education is important.
- You can never start saving too early, but you may be able to save too much.
- The future can be very uncertain, so retaining a level of flexibility can be beneficial to your overall financial plan.
Speak With a Trusted Advisor:
If you have any questions about debt repayment strategies, your investment portfolio, taxes, our 401(k)-recommendation service, or anything else in general, please give our office a call at (586) 226-2100. Please feel free to forward this commentary to a friend, family member, or co-worker. If you have had any changes to your income, job, family, health insurance, risk tolerance, or your overall financial situation, please give us a call so we can discuss it.
We hope you learned something today. If you have any feedback or suggestions, we would love to hear them.
Zachary A. Bachner, CFP®
If you found this article helpful, consider reading:
- Financial Planning Mistakes to Avoid
- Debt Repayment Strategies
- How to Negotiate a Raise
- Qualified vs. Non-Qualified Dividends