How to help clients invest for college without sacrificing retirement

One of the keys to successful investing is balance. Balance is also important when it comes to saving for life goals. For families, the question is often whether to save for college or retirement — or how to save for both, often at the same time, from the same pool of investible assets.
This conundrum presents itself as we anticipate rising college costs, the likelihood of entitlement reform, tax increases and lower market returns.
Striking a balance between saving for college and retirement is important, because emphasizing one over the other can ultimately jeopardize both. Parents who don’t accumulate enough for college may have no other choice than to take on crushing debt that limits their ability to save for retirement. On the other hand, those who can’t afford retirement run the risk of becoming the very financial burden they wanted their kids to avoid.
(More: Saving for retirement should be advisers’ top priority: Wharton’s Marston)
HELPING CLIENTS BALANCE THE TWO
So how can you help your clients with this balancing act? Three important recommendations can anchor this conversation:
1. Higher-earning families should increase their retirement savings rate to at least 15%, excluding any company matches, in an employer-sponsored plan.
2. Don’t lose the 20s decade. Start saving as early as possible, as young as 22.
3. Invest regularly and tax efficiently.
Why the change in the suggested retirement savings rate? Looking ahead, current and future retirement investors could face stiffer head winds than past generations. Taxes are likely to be higher. Stock and bond market returns may be lower than they have been in recent decades. Social Security could replace smaller percentages of workers’ paychecks. Health care expenses might rise faster than Medicare’s ability to pay for them. Put it all together and you get a longer, costlier retirement, funded more with personal savings, and fewer investment gains and government entitlements.
(More: Retirement readiness: 15% salary deferrals are the new 10% for 401(k)s)
And the higher education picture is not any prettier. Tuition costs are rising faster than household income, student loan debt is soaring and federal financial aid has actually declined by $23.4 billion since 2010-11. At the same time, college applications continue to rise, leaving fewer dollars to go around.
THE POWER OF SAVING 15%
Saving 15% each year becomes more powerful when the saving starts in the 20s. Today, the savings rate among younger Americans stands at an alarming negative 2%. Think of the missed opportunities.
Investments people make in their 20s can have the biggest impact on outcomes because they have the longest time to grow. Procrastinators will never get back that precious decade of compounding and may have to either save more than 15% in later years or risk falling short of financial goals. To achieve both retirement and college goals, we believe it is optimal to start saving the full 15% as early as 22.
Some practical advice can also help keep savers on the right path:
Assign savings to separate “mental accounts.” Instead of trying to manage one broad, undefined pool of savings, mentally assign some dollars to college and others to retirement. Money earmarked in this way is less likely to be spent or squandered for other purposes, especially if a separate investment vehicle is clearly earmarked for each goal. The amounts going into each mental account can be adjusted at different stages of life. Having separate accounts for each goal (i.e., 401(k) plan for retirement, 529 plan for college) – will help ensure that these goals are achieved.
Be a college investor, not just a saver. Most people are willing to take at least some risk with their retirement assets, but a child’s college fund tends to be viewed more emotionally and invested too conservatively. In fact, some of the most commonly used college vehicles include savings accounts and CDs now earning interest rates well below the tuition inflation rate. When families start planning early, college becomes a long-term goal suitable for longer-term investments with higher return potential.
Hands off retirement accounts. About one in five college savers expects to use retirement funds to pay for school. This is almost never a wise decision as it can negatively affect both parents and children. For parents, retirement withdrawals deplete the account and are generally subject to taxes, as well as penalties if made before age 59½. For children, those withdrawals are treated unfavorably as student income for financial aid purposes. Loans from a 401(k) similarly diminish the account’s earning power and must be paid back with interest.
Minimize the tax bite. Employer-sponsored retirement plans and, more importantly, their company matches have become absolutely critical to retirement security, yet less than half of Americans are eligible to participate. Even fewer families (29%) are investing on a tax-advantaged basis in 529 college savings plans. As a result, investment gains that could be going toward lifelong goals are instead eroded by taxes each year.
As with any goal, retirement and college outcomes depend, in part, on factors outside an investor’s control. Examples include market performance and tuition costs, as well as government policy regarding everything from taxes and financial aid to Social Security and Medicare. The key to success is focusing on those things that are well within an investor’s control. In other words, commit to an savings strategy, align each of your goals with a dedicated investment vehicle and remain steadfastly focused on long-term outcomes.
Michael Conrath is 529 Program Director at J.P. Morgan Asset Management.