The financial media has done a masterful job of convincing parents that they need to save for their kids’ college. That they better fork over as much money as they can as early as they can, and into a 529 account, please, ma’am.
I get asked all the time about saving for college. People who think they should but don’t know how or can’t fit it into their household budget. People who are saving but are worried it’s not enough or they’re doing it wrong.
I’m really impressed by the number of people who have embraced this advice to prepare and save and sacrifice on their children’s behalf. The only problem is, it’s a “point solution,” as my husband would say, which ignores other savings options, other college-planning considerations, and most grandly, your financial picture in its totality!
To be fair, the title is total clickbait (I admit it! I am so ashamed…) I think 529 plans are fantastic tools. And should have a place of pride in some of our plans. But not before we think through our whole financial picture.
529s Are Not the Only Good Way to Save for College
And I’m not talking about the more esoteric Coverdell ESA. I’m talking about just straight up saving and investing in a taxable investment account.
Everyone focuses on the tax benefits of the 529—that it grows tax free and all withdrawals are tax-free as long as you use it for education expenses—and true, those are pretty great benefits.
Let’s use a simplified example:
You save $20,000 when your child is born. It earns 8% annually until your child goes to school at age 18. Over those 18 years, that $20,000 will grow to $80,000. If that $80,000 is in a 529 plan, you can use all of it for college expenses.
By contrast, if you had invested that $20,000 in tax-efficient investments (like index funds) in a plain vanilla taxable investment account, your account would still grow to be pretty darn close to $80,000 because you’re not losing much to taxes each year. But when you go to use that money for college, you have to pay long-term capital gains taxes on the growth ($60,000). At a 15% rate, that means $9000 in taxes. If you’re subject to the 18.8% capital gains tax rate (although who knows what the rates will be in 18 years), that’d be $11,280 in taxes.
Pretty sweet. But I also picked a pretty optimal scenario: You save a bunch of money up front and let it grow for a long time. The shorter the time between investing the money and using it for your kid’s college, the smaller the tax benefit.
Also, you can think of the tax bill associated with a taxable account as the price you pay for flexibility. You can use that money in your taxable account for anything. At any time. If you use money in a 529 for anything but qualified education expenses, you not only pay federal income tax but a 10% penalty as well.
I would be remiss—and I almost was—if I didn’t mention behavioral considerations. That is, how to protect our money from ourselves. Our Stupid Brains have an annoying habit of convincing us to do Stupid Things with our money. Like withdrawing money from a regular investment account that is intended for college expenses…for things we convince ourselves we need, and not for college costs. A friend of mine likes 529s because they have a giant sign on them saying “This is for your kid’s college. Do Not Touch.” This is a Very Worthwhile Consideration. And you might find that having a 529 is the only way you can reliably save for college costs. Fair enough.
Saving Probably Isn’t The Most Important Part of Planning for College Costs
I sat through a demo of a college planning tool a few weeks ago. The software reflected the complexity of the college application process, college loan process, and financial aid process in its many screens and tons of data-input fields and many calculations. The size of your 529 was but one or two of hundreds of pieces of data the tool uses to calculate how much you’ll need to pay to send your kid to a particular college.
Admittedly, that’s not exactly a scientifically rigorous argument, but looking at the software is a good reminder that soooo many things affect how much you’ll need to pay for your kid’s college:
- School choice (probably the biggest factor in determining the financial impact)
- Federal financial aid
- School financial aid
- Third-party scholarships
- How much money you have in various types of accounts (taxable, 529, retirement, etc.)
- Your income
- Your child’s income and savings
Not to mention that who knows what the college landscape will look like in 10 or 20 years. That’s not to encourage you to give up and do no planning. But it is to make you realize it’s entirely possible that you can help your finances more by focusing on things other than saving.
“Put On Your Own Oxygen Mask First”
Or “You can borrow for college. You can’t borrow for retirement.” There are all sorts of pithy sayings for this truth: You need to save for your own needs before saving for your kids’ college.
Where Your Money Should Go Instead
#1. Emergency Fund. I can see you nodding your head in bored exasperation now. Yes yes, you say…I KNOW. So I’ll make it short: rule of thumb is at least 3 months of living expenses, in cash, in a real bank, where you can get at it easily and with no penalty.
And the more volatile your industry (say, oh, the tech industry) and the more volatile your company (say, a startup), the more money you need to save. The last time the industry truly melted down, in the early 2000s, it was not uncommon for people to be laid off and unable to find a new job for an entire year. Or hell, leaving the Bay Area (where I was at the time) entirely because the economy was so rough. It isn’t unreasonable to have an emergency fund equal to a year’s worth of expenses. You heard me right: 12 months of expenses, in cash, earning nothing.
#2. Retirement. For younger folk, you need to be saving at least 15% of your gross (pre-tax) income for retirement (and more if you want to retire early, or are pessimistic about Social Security). If you’re over, say, 40, you probably need to calculate a more personally accurate number for your savings rate. (Before age 40, retirement is Such a Distant Speck on the Horizon that getting too specific with that projection is folly.) I’m talking 401(k) or IRA or even just a regular investment account…as long as it’s intended for retirement.
I recently gave a talk to a group of women developers down at Microsoft (yes, I live so far north that I can say “down” at Microsoft in Redmond, WA). One of the women was curious about saving for retirement: she had successfully put both of her children through college with no debt, and now she was starting to think (dare I say, worry?) about her own retirement. <gulp> Her children might feel obligated to support her in retirement because of what she sacrificed for them. In this country’s financial culture, that worries me.
#3. “In-Between” Needs. A Lot of Life can happen between now and retirement. You could move. Your parent could get sick. You could want that once-in-a-lifetime vacation.
While you don’t know what’s going to happen in your life in the next 20, 30, 40 years, I hereby guarantee you that something will happen. The one way you can protect yourself against that uncertainty is to save for it.
For more predictable expenses like replacing a car every so many years or scratching your annual travel itch, set up a bank account and direct part of your paycheck to those accounts. This is a fairly easy calculation to make, as we can make reasonable estimates about car costs or how much we’re willing to spend on travel.
For those longer-term, unpredictable expenses, save to a taxable investment account. And invest the money.
How much to save isn’t the same for everyone. There isn’t even a rule of thumb, as there is for for retirement. Alas, this is something you’ll have to figure out—by yourself or by working with a financial planner—based on your own circumstances.
But remember! You can still use this money for your kid’s college! Sure, it won’t get the awesome tax benefits of the 529, but you will have had the flexibility of “use it anytime, anywhere, for anything”…and that’s worth a lot.
This is the same kind of flexibility we get by taking out a mortgage instead of depleting every last dollar we have to buy a home. Yes, we’d save on interest is we didn’t take out a mortgage, but then we’d have no financial cushion to fall back.
#4. NOW you can save for your kid’s college.
That’s a lot of savings to get through before starting to save for college, isn’t it? I like to think about college savings as something that other people do for my kids. Grandparents, birthday gifts, and the like.
But hell, there are the lucky among us who have enough money to get through all these more-pressing needs and still save for college. And for those folks, go for it.
Question: What’s the one thing you do that most effectively takes care of you? You can leave a comment below.
Do you want a financial advisor who thinks about the totality of your financial life, and will help you clarify your priorities? Reach out to me at or schedule a free 30-minute consultation.
Sign up for Flow’s Monthly Newsletter to effortlessly stay on top of my blog posts and extra goodies, and also receive my guide How to Start a New Job (and Impress Yourself and Everyone Else) for free!
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner and/or an accountant for advice specific to your situation. Reproduction of this material is prohibited without written permission from Meg Bartelt, and all rights are reserved. Read the full Disclaimer.