How to stack education savings

We have an awful lot of expectant physician client families right now – something in the virtual water, I guess! A common question is how to save for education. What accounts, how much, when, for whom and so forth. So this month’s Doctor Dilemma is for all of you parents-to-be and grandparents-to-be who are trying to sort this out.

When you’re planning for an expensive education, how do you look 18 years into the future and know what to save? As with most money decisions, the farther they occur from today, the more difficult it will be to hit the nail on the head…and we’re talking big bucks when it comes to education. One thing you don’t want to do is to subsidize your own retirement savings to put little Ahmed or Sara through Harvard only to have them turn into the next Bill Gates and thumb their nose at college. (Ok, maybe that wasn’t the best example.)

But, seriously, so much can happen between now and high school graduation. Some children won’t go to a traditional 4-year college, others will go to grad school and med school and others will have scholarships. Not to mention that we don’t know how tax laws will change between now and then and what an education will cost.

And what about elementary and high school now that 529 funds can be used for the younger years? Does it make sense to invest for private lower grades? Because money may be tight, especially in your first few years as an attending, you want to allocate limited funds properly and give them as long as possible to grow. Here are some general rules we go by at Fox & Co:

  1. Always maximize your own retirement savings There are no scholarships for retirement! That means, at a minimum, making 100% employee contributions for each parent along with backdoor Roth contributions. Be sure to get your full employer match. And if you have the opportunity for a Mega Backdoor Roth, take advantage before saving for your children’s education. If necessary, you can always take out tax-free principal for college.
  2. Decide how much you want to save for your children’s education. The SavingForCollege website has a really nice college savings calculator to estimate future costs for most any U.S. college or university. Do you want to fund 100% of med school? Do you want your children to understand how to borrow and pay back student loans and/or work during school? Parents need to discuss beliefs and principles and come to a conclusion. I’ve found that many couples have differing views on what their children should be responsible for so maybe you should have this talk before starting a family!
  3. Once you have a funding goal, we recommend allocating 75% – 80% of that amount to 529s and Education Savings Accounts (Coverdell ESAs) and 25% – 20% to a taxable account. This gives you wiggle room if you don’t need all of your savings for school while allowing you to have 100% funding. Of course, recognize that savings needs will change through the years with rates of return and changes in future costs.
  4. Fund the tax-free growth first (529s and ESAs) so that you’ll pay the least amount of tax at withdrawal. Remember, you’ll pay tax on any growth in the taxable accounts, so you can fund those last. The more you can front-load your accounts, the greater tax-free growth you will have available in the future.
    • If you cannot fund both, prioritize the ESA. The reason? You are limited to a $2k contribution each year from birth only through age 17. As with a backdoor Roth IRA, if you skip a year, you’ll never be able to make it up!
  5. Invest and manage these accounts properly. This article isn’t about choosing the best 529 fund – there is plenty on the net about that – but about having the education savings you need where and when you need it. I’ve got a great article here about the relevance of fund fees and how to have optimal growth in your accounts. We’re frequently asked about dialing down the risk as the child approaches college. Here’s what I believe: if you can afford to pay out of pocket should the market nosedive and can defer your savings to a later year/younger child, I’m not typically in favor of bonds for 529s. That is a deeper conversation than I’m prepared to have here, though.
  6. About funding private elementary and high school – I’ve saved this for last because most people who can afford a private education for their children are planning to pay cash. But because the tax law now allows you to spend $10k/year from 529 accounts for each child, you can have a plan to pay for at least part of these costs with tax-free growth. Here are some tips:
    • Don’t plan to use your 529s until grade 6, but be prepared to take withdrawals if you have had good growth (say, 8% – 10% annually).
    • If the market is down when tuition is due, be prepared to pay cash. In other words, keep a liquid cash account you can tap for at least the first few years of private school, if necessary.
    • Set up a Coverdell ESA for each child at birth. Having an ESA will allow you to supplement the $10k – 529 withdrawal limit, if necessary. You can contribute only $2k/yr per child, but it can make a difference. And, yes, it is easy to get around the income limit. You simply give the money to a lower income trusted family member, friend, or your child’s UTMA and let them make the contribution instead.

529s and their Tax Benefits

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