Save for Retirement and Borrow for College Instead

March 10, 2011
Janet L. Critchley, CPA, PFS, MST

Many parents don't want to burden their children with college loans, but young people have a lifetime of earnings ahead of them they can use to pay down their debts. Parents can't borrow their way into retirement.

Many parents don’t want to burden their children with college loans, but young people have a lifetime of earnings ahead of them they can use to pay down their debts. Parents can't borrow their way into retirement.

Parents with good incomes who can afford to pay for college outright should reconsider if it requires stopping contributions to their 401(k), SEP, 403(b), or other tax-favored accounts while their children are in college. It’s better to keep contributing to these plans and borrow whatever funds are needed.

Consider this scenario. Two 50-year old spouses each earn $125,000 when their oldest child enters college. The younger child will start college right after the older one graduates, so the couple will have a child in college for a total of eight consecutive years. Total college costs per child are $44,000 per year. Both parents intend to retire at age 65.

Instead of paying for college, both spouses contribute the maximum allowable $22,000 ($16,500 annual contribution, plus the allowable $5,500 IRS catch-up contribution for people age 50 or over) per year to their 401(k)s, and each gets a 3% employer match. Together, they are saving a total of $51,500 ($44,000, plus the $7,500 match). The couple and/or their children will borrow the money needed for education.

Their eight years of contributions, from age 50 through 57, at an 8% rate of return, plus their continued contributions through age 65 will accumulate to $1.624 million in tax-deferred savings accounts by the time they retire.

Assuming a 6% after-tax rate of return (and factoring in 3% inflation), that money could provide $131,000 in income per year for 15 years, or $105,000 per year from age 65 through 85.

In contrast, if they contribute nothing to their 401(k)s from ages 50 through 57, but resume the same level of contributions at age 58, they will have only $570,000 in savings at 65. Missing out on eight years of contributions, along with tax-deferred growth, reduces their savings by $1.054 million. The retirement picture is far grimmer than if they had not ceased contributions for eight years: Their $570,000 in savings would generate only $46,000 a year for 15 years or $37,000 for 20 years.

Although the cost of borrowing has not been factored in, clearly the best choice for the couple is to continue all contributions from ages 50 through 65. This would allow them to assist with loan payments after college should their children run into issues in paying the loans. Most importantly, continuing contributions will provide a much more comfortable lifestyle in retirement.

Tackling the Tuition

After factoring in scholarships, grants, and financial aid, if the parents don’t pay the remaining tuition outright, either they and/or their children will have to borrow the money. There are many options, including federal government loans such as a Stafford loan (taken out by the student), or Parent PLUS Loan, and private loans, such as a home-equity loan (the interest paid is tax-deductible). Some of the loans require interest payments during the college years.

Although it may seem counterintuitive to saddle your children with a lot of debt, it is much worse than not having enough money for retirement. Parents who’ve saved more in their retirement plans will not only be more financially secure in their elder years, they will also be in a much better position to help their adult children pay down debts, should the need arise.

Janet L. Critchley, CPA, PFS, MST, is a financial analyst with Brinton Eaton in Madison, N.J. Brinton Eaton is an advisory firm with a long history of serving individuals and their families across multiple generations. The firm helps its clients protect, grow, administer, and ultimately transfer their legacy of wealth through a full range of integrated services, including lifetime cash flow projections, financial/tax/estate/retirement planning, investment management, charitable giving, and business succession planning. For more information, visit Brinton Eaton's website.