Often, when a client has a new baby, their first financial question is, “How much should we save for his/her college?” I love this eagerness and willingness to think long-term savings for the child, however I increasingly find myself telling them to “pump the breaks a little bit.” I don’t say this because I don’t want them saving money or that I think they shouldn’t pay for their kid’s college, but rather I am considering my client’s financial flexibility as well as financial future.

In general, when it comes to a client’s goals, there are an abundance of variables that could positively or negatively affect those goals. When it comes to college funding for kids, the most basic questions I address are: How much of college do you want to fund for the kid(s)? Do you want them to have skin in the game in the form of loans or cash themselves? Do you think you might qualify for financial aid down the road? Where does this goal rank in a list of your financial priorities?

If the client has a desire to fund some percentage of education for their kid(s), I review the clients’ cash flow in respect to their other goals and we look at different scenarios in which we can save additional money each year OR where we should pull savings from in order to save for this education expense. Most of my clients are familiar, at least vaguely, with 529 education savings accounts. These can be powerful tools to save for college education while taking advantage of a state tax deduction and tax-free growth on the investments. The downside to these accounts is that once funds are deposited into the account, in order to maintain the tax advantages of the account, you must use the funds for college-related expenses. While the list of expenses is fairly inclusive and accounts for items outside of just tuition and room & board, it is still restricting when compared to an after-tax brokerage account, which can be used on anything at any time.

When viewing the after-tax brokerage account in comparison to the 529 account, the biggest difference that jumps out is the lack of tax advantage. When you put money into a brokerage account it has already been taxed. Then when you sell the investments in the account to remove money from the account, you are taxed on any gains on those sales.

While 529s are created in the federal tax code, there are several facets that are controlled at the state level, making it very important to pay attention to your state of residence before making decisions around 529 funding. Most states offer a state tax deduction for contributions each year up to a certain limit (this limit varies based on the state). For example, Michigan allows a married couple to deduct $10,000 per year while Virginia only allows $4,000 to be deducted per year, whether you are married or single. In Michigan, where the state income tax is 4.25%, the most you can “save on taxes” each year is $425.

It is for this reason that when parents come to me wanting to save a certain amount for college education for this child, instead of suggesting they immediately fund a 529 account from the time the child is born, I often suggest using an after-tax brokerage account in the near term and then re-evaluating the closer the child gets to college. This gives the family much more flexibility in their financial plan for three main reasons:

• If the kid decides to not go to college, the parents can use those brokerage funds for another goal of theirs or gift it to their kid in another form.
• If the kid obtains large amounts of scholarships or grants and doesn’t need the full amount the parents set aside, the funds can be reallocated.
• If the kid goes to college, the parents can simply run those brokerage funds through the 529 account closer to the date of college to collect the tax deduction without giving up the flexibility.

In scenario 1 & 2, the parents are significantly better off and do not have to worry about pulling the unused money out of the 529 and paying taxes and a penalty on it. While in scenario 3, the parents have lost out on the tax advantaged growth of the funds in the 529 but gained the increased flexibility due to the dynamic structure of the brokerage account versus the 529.

The key to education savings is to save somewhere that will provide you some rate of return over time, otherwise you will lose to inflation big time. Increases in education costs have outpaced inflation for quite some time now. While there are pros and cons to all education savings strategies, some of which I haven’t had a chance to mention here, I like giving my clients options when it comes to their financial future. There are only three things that are certain in life: death, taxes, and that life will change. So why not prepare for an ever-changing life with flexible strategies?