Eager to Save for College? Let’s Take a Step Back

Often, when a client has a new baby, their first financial question is, “How much should we save for college?” I love the eagerness and the focus on long-term savings for their child’s future. However, I often find myself advising clients to “pump the brakes a little bit.” Not because I discourage saving or paying for college, but because I am considering their overall financial flexibility and long-term stability.

Clarifying College Funding Goals

When it comes to a client’s goals, there are always a host of variables that could positively or negatively impact those goals. For college funding, the most essential questions I cover with clients include:

• How much of college do you want to fund for your child(ren)?
• Should the child have “skin in the game” in the form of loans or cash contributions?
• Will you likely qualify for financial aid?
• Where does this goal rank among your other financial priorities?

Cash Flow and Education Funding Options

If the client wants to fund a portion of their child’s education, I start by reviewing their cash flow and financial goals. Together, we explore different scenarios to determine if they can save additional money each year or decide where to reallocate existing savings for education expenses.

The 529 Plan: A Powerful Yet Restrictive Tool

Most clients are at least somewhat familiar with 529 education savings accounts, which can be an excellent tool for saving on college costs. These accounts offer state tax deductions and tax-free growth on investments used for college-related expenses. However, funds in a 529 must be used for qualified education expenses to keep the tax advantages, which can be restrictive compared to an after-tax brokerage account, which offers more flexibility in terms of use.

Brokerage Accounts vs. 529 Accounts: Key Differences

When comparing an after-tax brokerage account to a 529 account, the biggest difference is tax advantage. Brokerage account funds are already taxed, and additional taxes apply when gains are withdrawn.

On the other hand, the 529’s tax advantages come with limitations. Though created under federal tax code, many aspects are controlled by the state. State-level rules around tax deductions for 529 contributions vary widely. For example, Michigan allows a married couple to deduct up to $10,000 per year, while Virginia caps deductions at $4,000 per year. In Michigan, with a 4.25% state income tax rate, the maximum annual tax savings is $425.

Flexibility in Financial Planning: The Case for a Brokerage Account

For this reason, rather than recommending that parents fund a 529 immediately, I often suggest starting with an after-tax brokerage account in the early years and re-evaluating closer to the child’s college years. This approach offers much more flexibility in their financial plan for three main reasons:

1. Alternative Uses if College Isn’t in the Plans: If the child chooses not to attend college, parents can repurpose brokerage funds toward another goal or gift the funds in another way.
2. Reallocation if Scholarships or Grants Are Awarded: If the child earns substantial scholarships or grants, the funds can be reallocated without penalty.
3. Simple Transfer if College is the Goal: If the child does attend college, the brokerage funds can be transferred to a 529 account closer to the college years to take advantage of the tax deduction without giving up flexibility.

In scenarios 1 and 2, parents avoid the tax and penalty for unused 529 funds. In scenario 3, while they may miss out on tax-advantaged growth in the 529, they’ve gained flexibility and avoided the limitations that 529 accounts bring.

The Key to Education Savings: Flexibility and Growth

The most important factor in education savings is to save in an account that allows for growth to keep pace with inflation. Education costs have consistently outpaced inflation, so it’s essential to have an investment strategy in place. While each savings strategy has pros and cons, I believe in providing clients with flexible options that support their financial goals.

As they say, three things in life are certain: death, taxes, and change. Preparing for an ever-changing life with adaptable financial strategies is often the best approach.

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