Stop Contributing to Your Kid’s College Fund Now

Last week, I laid out where your long-term savings should go in Put Your Retirement Savings in These Accounts First.  You may have read this and wisely observed that I missed a great class of tax-advantaged savings accounts:  college funds.  Sure, they aren’t for retirement savings, but shouldn’t you contribute to your kid’s college fund somewhere in the middle of that list?

There are several ways that you can save for a child’s education.  This article sums them up with pros and cons for each.  My preference is a 529 if you are going to earmark savings for your child and what I am about to say doesn’t convince you otherwise. In that case, put the money in right away to give it some time to grow. 

But first read this…

I started contributing to a 529 when my daughter was born in 2015.  Then I stopped.  It has grown to about $10,000 today, which will be helpful, but it won’t come close to getting her through college in the 2030s! 

Tuition varies widely across the nation. According to US News and World Report, average tuition and fees for public colleges are $10,388 for in-state and $22,698 for out-of-state students.  Private colleges charge an average of $38,185 per year. 

Living expenses in many college towns have skyrocketed as well, and rent alone can easily match tuition costs.  My jaw dropped when I read that the average 1 bedroom apartment in Boulder, CO rents for $2,067/month.  It appears that I just moved from a top 25 cheapest college town (Tucson) to a state with a top 10 most expensive college town!

This is why I stopped contributing to my daughter’s college fund despite these eye-popping numbers—and you should probably stop too:

1         She may decide not to go to college

There are good and bad reasons for someone to skip college. 

Keep flipping burgers for a few months, then backpack the Continental Divide Trail and become a ski bum for a year to “find yourself”?  Bad plan.

Work full-time in the family business. Mentor under a senior salesperson., Attend trade shows. Self-study using the vast library of books, podcasts, and free online classes. Then take over the top job when you are ready?  Good plan.

I will raise my daughter with the mindset that she is going to college.  However, if she has a good reason not to go—such as continuing to build the $1M online business that she started in high school (it doesn’t hurt to dream) or to keep working as a realtor in her home town where she’s already shown desire, ability, and has built a strong network—then I won’t try to convince her otherwise.

2         She may get a scholarship

I went to school on an academic scholarship, and if my daughter turns out to be a good student or athlete she could as well. 

I’ll encourage her to apply for as many smaller scholarships as possible if she doesn’t get a full-ride.

Many students have successfully strung together a series of smaller scholarships that cover a large part of their tuition.  Applying for scholarships can easily be the highest paying job for a college student.

Check out this article for tips on how to win scholarships.

If my daughter doesn’t go to college or has a scholarship to pay for it all, then I will be happy that I didn’t over-save in my 529.  There is a 10% penalty on gains if not used for qualifying education expenses, and that would come on top of capital gains taxes.  So the last thing I want to do is put money into the account that she can’t use.

3         She can work through college

I worked on weekends as a bus boy and drum teacher through college to pay for rent, food, and gasoline. 

I want my daughter to have similar responsibilities and the character growth and time-management skills that come from that.  Work can help her realize that college isn’t just for hanging out all night and sleeping in on weekends. 

I also want her to have a sense of urgency to finish in 4 years.  After all, the best way to control costs once a school has been selected is to finish on time!  What’s the rush if someone else is paying for everything? 

I suppose an alternative could be to tell her I will stop paying as soon as 4 years is up. That’s what my scholarship did to me when I needed one final semester to get my degree.

I recently listened to the audio book Skin in the Game by Nassim Nicholas Taleb, one of the greatest thinkers of our time.  This book goes far beyond the college funding context, applying the “skin in the game” concept to all aspects of life.   But I am convinced that my daughter—and anyone else for that matter—will value money and education more if she has some of her own skin in the game.

4         A college fund isn’t really a long-term investment account

Retirement account timelines are 60+ years with the goal of preserving capital through the end of your life. 

College savings account timelines, by comparison, are about 22 years with the goal of spending it all.

Retirement accounts are invested for many decades of growth and preservation.  Even in the middle of retirement, they need to last for decades more.  They are never intended to run out of money, and whatever remains at the end of your life will go to your heirs and charity.  This allows you to invest more aggressively and with a long-term mindset all the way through.

A college savings account is invested for about 18 years before withdrawals start.  Then it is taken to zero in 4 years or so. 

I might be able to take a longer-term view if I was actually intending to re-assign the account to an unborn grandchild. That’s where any leftover funds would likely go.  But then we repeat all of the same arguments and unknowns for my grandchild that I am making for my daughter’s college funding source and needs.

5         The short timeline will cause me to invest too conservatively

The sequence of returns risk that I wrote about in this article for pre- and post-retirees is amplified for pre- and present college students!

The relatively short timeline before my daughter goes to college will cause me to invest conservatively by the time she is in middle school. That’s the only way I can count on the money being there when she needs it. 

I will need to start reallocating the investments in a few years to reduce volatility.  This will also reduce the expected growth of the fund. But it will increase the certainty that there will be enough money in it on day 1 of college.

Her college fund will need to have 80% or more in short-term bonds and cash by then if I don’t want to take too much risk.  This is much more conservative than the PathwayToFI model portfolios because of the much higher withdrawal rate.

College funds are drawn down by about 25% per year.  This means their investments need to be much more conservative than a retirement account!

6         The tax advantages aren’t very substantial because of the short timeline

College funds like a 529 and Educational Savings Account (ESA) grow free of federal taxes. For some states, earnings are free of state taxes as long as they are used for qualifying expenses. 

If you are going to fund a 529 or ESA, front-load it so it has time to grow!  Late contributions save little in taxes and make almost no difference with simply paying for college out of pocket.

Every year, there are diminishing benefits for making new contributions to a college fund.  My daughter started first grade this year. If I contribute new money now, I only have 12 years before 80-90% has to be in bonds and cash.

I’ll probably wait for a new all-time high in the market before reducing stock exposure. My portfolio might look something like this, assuming that happens in the next few years:

There aren’t many years of potential high growth left. 

At best, a $1,000 contribution at age 7 might grow by 50% to $1,500 before it’s withdrawn.  Tax savings on $500 of capital gains in the 15% tax bracket is $75. Savings might be much less if you would otherwise have done some tax loss harvesting at your higher 22% or 24% income tax bracket.  I wrote more on tax loss harvesting in this article. 

This isn’t a ton of money to argue over, particularly considering the next point.

7         I can fund my daughter’s Roth IRA and I bonds instead

I can open a Roth IRA for my daughter as soon as she starts earning an income. Then I can match her income dollar-for-dollar with Roth contributions up to the current IRA limits. 

This will provide a good opportunity to teach her about saving, investing, tax shelters, and compounding returns.  It also incentivizes her to find a well-paying job in high school and learn work ethic.

Contributions can be withdrawn without penalty to cover college expenses if needed, leaving the earnings to grow tax free.  The earnings themselves would be worth over $113,000 at age 65, assuming contributions of $6,000 from age 15-18 and an average investment return of 8%.

If she doesn’t need any of the money for college, and instead keeps it all invested in the Roth until she turns 65, this alone will make her a millionaire! 

Or she can use the contributions for a down payment on her first home. The earnings can again be left to grow for retirement from there.

I can also buy government I bonds for her, which have a great guaranteed interest rate as I am writing this.  I bond interest is tax free also.

These are much more flexible options for her future than a college fund if I can’t afford to save for all three in my order of operations.

8         I can always help her cash flow any shortfalls if needed

Let’s consider the worst case. 

1. My daughter doesn’t get any scholarships despite dozens of applications. 
2. She goes to an in-state school because I won’t help her with private or out-of-state tuition.  She chooses University of Colorado Boulder, though, so rent is high!  Maybe out-of-state doesn’t sound that bad after all…
3. She wasn’t able to earn much money in high school, so her Roth IRA is small. 
4. I decided to use her I bonds to pay for braces for her during high school, so those are gone. 
5. She’s also struggling to find worthwhile employment in her new college town.
6. My $10,000 college fund doesn’t grow enough over the next 12 years to keep up with tuition increases. So it doesn’t pay a full year of tuition. 
7. And my writing and coaching are not making any income 12 years in.

It’s hard to believe everything will work out this way, but we’ll go with it.

My real estate income and retirement account withdrawals will still disqualify her for financial aid according to this article.  But I wouldn’t plan on government assistance anyway.

With all of this working against me, I still have options to help with her school costs. 

First, I can use income from my own investments to help her cash flow college.  I might need to cut back on some travel or other discretionary expenses. That’s what parents have to do sometimes to help launch a child. 

IRAs can be used without penalty to pay college tuition for children according to this article.  This is just one more way that retirement accounts can be used before age 59 1/2. Just one more reason that I need to max out my own retirement accounts before ever considering a college fund!

What if my investments haven’t performed well recently, and helping her cash flow college could lead to an insecure retirement? My next option is to pick up some extra income myself. 

I probably would enjoy an interesting part-time job at the forest service, parks and rec, or coffee shop. I would meet new people and make some extra cash that way.  Or I could dust off my suit and tie and fall back to my engineering background to find a better paying consulting job.

9         She can get a small student loan as a last resort

It wouldn’t be the end of the world if my daughter had to get a small federal student loan—say, around $10,000.  She will have plenty of time to pay it back, and would likely have a low enough interest rate to make it manageable.  This is another use of the skin in the game concept as long as I make sure she understands what she’s signing up for and the effort it will take to pay back.

Besides, she’ll only be encouraged to go to college for a degree with a high return on investment: engineering, computer science, architecture, business, healthcare, law, etc.

A small student loan would be better for her than if my wife and I were to sacrifice our own retirement by trying to help her when our remaining lifetime earnings are very limited.

And hey, if the recent actions by the government to forgive student loans are any indication, they might forgive it anyway!  OK, maybe counting on that is not a good plan.

10         The best thing I can do for my daughter financially is to make sure that she never needs to help me

My savings priority is to first max out my own retirement accounts and to make sure that I will be financially independent for life.  Only then should I worry about funding any accounts specifically for her future—Roth included.

I have friends who are helping their elderly parents financially, and it’s not good for anyone.  This flips the parent-child relationship upside down, and creates bad feelings on both sides.  It puts a strain on the relationship that can make family gatherings and holidays stressful and unpleasant when they should be full of joy. 

I am giving my daughter full control over her financial future and her own path to FI by making sure that she never has to worry about her parents’ finances.

“Put on your own oxygen mask before assisting others.”  —Randy Pausch

11         Summary

These are the 10 reasons that I stopped contributing to my daughter’s college fund, and you probably should too:

1. She may decide not to go to college
2. She may get a scholarship
3. She can work through college
4. A college fund isn’t really a long-term investment account
5. The short timeline will cause me to invest too conservatively
6. The tax advantages aren’t very substantial because of the short timeline
7. I can fund my daughter’s Roth IRA and I bonds instead
8. I can always help her cash flow any shortfalls if needed
9. She can get a small student loan as a last resort
10. The best thing I can do for my daughter financially is to make sure that she never needs to help me

Save first for your retirement security.  All other financial goals will fall in line if you do that effectively.

Contact me directly or on social media if you have any questions or comments.  I expect a few of you to disagree on this one, and would love to hear the counter-arguments!

You can also keep up with the latest articles and insights from PathwayToFI and take a look at the Model Portfolios as well as my own asset allocation over the years by signing up for free at the bottom of the page.

Join me on the path to FI!