Early Retirement and Paying for Kids’ College: Are They Compatible?

Prioritization is the keystone of any successful financial plan. This is especially true with retirement planning, and even more so with early retirement. So, what happens if you would like to retire early, but have children slated to start college right around the same time? How do you prioritize both saving for your retirement AND saving for tuition?

Typically, the topic of early retirement tends to overlook two very important expenses, either of which could be game-changers. Paying for college education is one of those expenses (health insurance is the other). If you plan to retire early, you’ll need to work extra hard to ensure that your budget has accounted for both of them.

Early retirement is a massive financial undertaking. At its core, it’s the process of taking retirement, an already-stressful project in itself, and fast-forwarding everything. Is there space in your budget to handle another big ticket item, like funding college? If you have children, and you want to provide for their education, you have no choice but to make room.

Determining the Cost of Both Goals

Let’s say that you have calculated what you need in order to retire early, at age 50. It turns out that you will need an investment portfolio of $1 million. If you have children, and they will be in college between now and then – or even shortly after you retire – you’ll have to figure that into your future calculations.

So, how much are we talking?

According to the College Board, the average annual cost of college for the 2015-2016 school year is $19,548 at an in-state four-year college, and $43,921 at a private college. That includes tuition and fees, as well as room and board.

A four-year stint at a state college will cost nearly $80,000, or $176,000 at the average private university. Now, multiply those totals by the number of children you’re putting through school to get an idea of what your future education costs will be. If you have two children, for example, and you expect each to attend a private college, you will need to have over $350,000 set aside to cover it.That’s not chump change.

Under this scenario, you will need $1.35 million by the time you’re 50. That’s a nice little bump from the $1 million that you were originally planning on for early retirement alone.

What are your options?

You May Need to Delay Retirement

Providing a college education for your kids doesn’t make early retirement impossible, but you may need to alter your plans. The most obvious change would be delaying retirement until your youngest child has graduated from college. That will ensure you have earned income to help shoulder the cost of providing for school, rather than relying entirely on savings.

There’s less of a problem if graduation and early retirement are expected to occur at the same time. For example, say you’re 30 years old, have two children (ages six and four), and plan to retire at 50. By the time retirement day rolls around, your kids should have already graduated.

But if you’re 30 years old, your kids are only two and one, and you want to retire at 45, there will be overlap. For you, delaying retirement may be necessary.

Shifting your early retirement probably won’t be based on a specific date. More likely, it will take place when your investment portfolio rises to the level where it can cover both retirement and tuition. As that time approaches, you will have a better idea of where your kids will go to school, how much it will cost, and whether or not they will get any academic and merit scholarships or grants.

You Might Need Three Distinct Investment Portfolios

Early retirement and funding college education can be compatible, but you may need to establish three distinct investment portfolios to get the job done.

The three portfolios can be broken down into:

  • A dedicated retirement portfolio
  • A dedicated college funding portfolio
  • A “swing portfolio” that can make funds available for either goal

The retirement portfolio is easy enough. If you are employed, that will include a 401(k) plan, 403(b) plan, 457 plan, or some other employer-sponsored retirement plan. If you’re self-employed, it can include a solo 401(k) plan, SEP IRA, or SIMPLE IRA plan. And whether you are employed or self-employed, you may also have a traditional IRA.

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These accounts can be expected to provide the bulk of the funds that will be necessary to fund your early-retirement.

On the college funding side, you can set up either a uniform gift to minors act (UGMA) plan, or a 529 plan for each of your children.

These plans should provide sufficient funding to cover the lower end of expected college costs. You could start by planning to save $80,000 for each child, under the assumption that they will be attending a four-year, in-state college.

What if college ends up costing more?

Keeping Your Options Open: The Third Investment Portfolio

Saving for both college and retirement is an attempt to juggle two very large financial goals at the same time. Complicating it further? The fact that you can’t know exactly what each goal will require. This means you will have to build flexibility into your planning.

You certainly want to make sure that you have enough money going into your first portfolio to cover your early retirement. But the college education portfolio will be something of an “X factor.” Will they attend an in-state school, or a private university? What if one kid decides not to go to college at all? The difference between the three outcomes is nearly the size of a home mortgage!

That’s where you’ll need flexibility. And that’s also where the third investment portfolio enters the picture. It should act as swing funds between college and retirement, to account for the unknowns.

Take a Peek Inside My Investment Portfolio

One simple guideline is that the third portfolio be set up to cover the high end of expected college costs. (Less the amount that you have already saved in the second portfolio for the low end costs.). For example, if you have two children, the high end could be $350,000. This is the average cost to send two kids to private college for four years (according to the aforementioned study).

You would then subtract the amount you are already saving for a low end education — $80,000 per child, or $160,000. That means that the third portfolio should be in the neighborhood of $190,000 ($350,000 – $160,000).

If you set up three distinct portfolios, you’ll be prepared for whatever will happen. But where to invest the third portfolio will be critical.

As a general rule, you want to have the money invested in vehicles that are not tied specifically to retirement or college education. That will give you the ability to use the funds for whatever purpose that you need.

You can use the third portfolio to fully fund your kids high-end college educations, if needed. If their schooling costs less, the third portfolio can then be used for your retirement. You’ll have both goals covered.

Now, how do you invest that?

Non-tax Sheltered Investments

Non-tax sheltered investments are an excellent choice for the third portfolio. Because they are not tax sheltered, there is no simmering tax liability waiting to bite you when you withdraw the money. You can use it either to pay for higher college expenses, or you can use it for retirement.

In fact, non-tax-sheltered investments are also a perfect source of income for those who retire early, and need to begin tapping savings before they turn 59 1/2. You can live on these funds until you are eligible to make penalty-free withdrawals from your tax sheltered retirement plans.

There’s also complete flexibility here. You can invest through a regular taxable investment brokerage account. You can also invest in stocks, bonds, mutual funds, exchange traded funds, options, and real estate investment trusts.

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No, there are no tax benefits to saving and investing in this manner, but it will provide you with the kind of flexibility that you will need in trying to juggle two major financial goals at the same time.

A Roth IRA — The Best of Both Worlds?

There is one investment that can give you the benefit of both tax favored investing, and access to your money for purposes other than retirement, and that’s the Roth IRA. It might not be an exaggeration to say that having a Roth IRA is a necessary component of preparing for early-retirement. It provides the kind of flexibility that early retirees will need.

Like other tax-sheltered retirement plans, Roth IRAs provide tax-deferred accumulation of investment earnings. Withdrawals from the plan are tax-free if you are at least 59 1/2 years old, and have been in the plan for a minimum of five years.

However, since Roth IRA contributions are not tax-deductible, they can be withdrawn without being subject to tax or an early withdrawal penalty. You can withdraw the amount of your contributions to pay for your kid’s college expenses, without any tax consequences (IRS Ordering Rules for Distribution allow you to withdraw your contributions first, then your investment earnings).

You can also withdraw your investment earnings. They will be subject to regular income tax, of course. However, they will not be subject to the 10% early withdrawal penalty if the funds are used to pay for education.

A Roth IRA is a way to access retirement savings to provide for your children’s college education, with reduced tax liability. That can make it a perfect component of your swing portfolio. And if you never have to tap the account for college or for any other purpose, it will remain available for its original intent, which is your retirement.

This is a bit of a complicated topic to be sure. It’s a necessary one to consider, though. Especially if you are planning on early retirement and have children who will need funding for college.

If you’re planning for early retirement, what strategy are you using to cover education expenses?

 

Topics: Money Management
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