Should You Save for College or for Retirement?

Some personal finance pundits recommend that parents should save for retirement first, college second. They argue that financial aid is available for college but not for retirement, that one can borrow for college but not for retirement, that assets in qualified retirement plans do not affect eligibility for need-based financial aid, and that parents should take care of their own needs first.

This advice is clichéd and wrong.

Their justification is flawed. For example, more financial aid – in the form of Social Security benefit payments – is available for retirement than for college. One can borrow for retirement through a reverse mortgage, although that is not recommended. A Roth IRA is not really a dual-purpose savings vehicle for college and retirement because a tax-free return of contributions is counted as untaxed income on financial aid application forms, potentially wiping out eligibility for need-based financial aid.

The financial arguments about saving for retirement first are not really analyzing the financial tradeoffs of saving for college or for retirement. Instead, these arguments implicitly assume that someone other than the parent will be paying for the child’s college education. A more rigorous analysis yields a more nuanced and balanced approach to saving for college and retirement.

Most People Do Not Save Enough

Most people do not save enough for college and retirement. Parents should aim to save about a third of future college costs. Of the parents who save for college, the average savings is only about 10 percent of the cost. People should save about one fifth of their gross income for the last fifth of their lives. Yet, the average retirement savings rate is only about 7 percent of gross income. Few save even close to the annual contribution limit on their 401(k) retirement plans.

Maximize Total Combined Assets

Savings strategies should be based on a balanced goal of maximizing the overall net return on investment.

This usually means preferring savings over debt. If the after-tax interest rate paid on debt exceeds the after-tax interest rate received on investments, directing money at paying down the debt instead of directing it at increasing investments will save money. Avoiding the interest paid on a loan is like receiving the interest tax-free. For example, suppose a parent has a choice between investing the $10,000 in a Certificate of Deposit that pays 2% interest or paying off a $10,000 loan that charges 14% interest. If the parent chooses to save the money, he or she will earn $200 on the investment, but pay $1,400 in interest on the debt. Paying off the debt saves $1,200 more a year than investing the money.

So, the optimal strategy is to rank debts and investments by the after-tax interest rate, directing extra money at the option with the highest after-tax interest rate. If the debt charges a higher interest rate, paying down debt and avoiding the need for debt will save more money overall. (A similar rule applies when a college graduate is deciding whether to save for retirement or to prepay his or her student loans. Always base the decision on the after-tax interest rate on each option.)

By saving for retirement instead of also saving for college, the parent will have to borrow from the Federal Parent PLUS loan and private student loan programs instead of using savings to pay for college. If the interest rates on the education loans are higher than the interest rate on the investments, by the time the debt is paid in full, the parent will end up with less money for retirement than if he or she saved for college and for retirement.

For example, suppose the parent plans on saving $1,000 per month total. In one scenario, the parent saves $250 per month for college and $750 per month for retirement for 17 years and the full $1,000 for retirement for the remaining 23 years of the parent's 40-year work-life. In the other scenario, the parent saves $1,000 per month for retirement for 40 years and nothing for college. Instead, the parent will borrow Federal Parent PLUS loans with a 10-year repayment term. The loan payments will reduce the amount contributed for retirement until the loan is paid off. Assume a 6 percent interest rate on savings and an 8 percent interest rate on the loans. In the first scenario, the parent accumulates $1,649,889 for retirement, $55,685 more than the $1,594,204 saved for retirement in the second scenario. The difference is due to the loan diverting $175,756 in contributions toward loan payments in the second scenario, almost double the $88,749 saved in the first scenario. So, even though the college savings reduces the total saved for retirement, borrowing money at a higher interest rate reduces the potential retirement savings by an even greater amount. This analysis is based on the saving for college vs. retirement calculator

Practical Tips

Before saving for college or for retirement, build an emergency fund of 3-6 months’ salary in a liquid investment, such as a bank savings account or a money market account. Some people recommend saving 6-12 months’ salary. The goal is to have enough money to cover living expenses for the average time between jobs. Even in the most recent economic downturn, the median duration of unemployment was 4-5 months. The average (mean) duration of unemployment, however, was 9 months, due to about a third of unemployed people having been unemployed for an extended period of time.

Then, the use of money that is available for savings should be based on the following principles:

  • Maximize the employer match on contributions to the employee’s retirement plan, since that is free money.
  • Pay off high-interest debt, such as credit card debt. Any consumer indebtedness with double-digit interest rates should be paid off before even considering potential investments.
  • Many 529 college savings plans offer a superior investment opportunity than a Roth IRA. While both involve investing after-tax income, many states offer a state income tax deduction or credit on contributions to the state’s 529 college savings plan.
  • Invest the money in the opportunity with the highest after-tax return on investment.
  • If both college savings and retirement savings offer a similar return on investment, prioritize the financial need with the shorter time horizon. In most cases, the most immediate expense will be paying for college, not retirement.
  • Otherwise, balance the two goals, while preferring options that minimize current debt and avoid a future need to borrow.
  • Live below your means, so you have the means to live.
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