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Prioritizing Savings

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Parents often ask how they should prioritize their savings. Given that you can save a limited amount of money per month, how should this savings be allocated among the various savings goals, such as saving for college and saving for retirement? If you haven't yet saved for retirement, should you save for college first or retirement first, or should you save for both? If you save for both, what split do you use? What about saving for other life cycle events, such as buying a house or a car?

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There is no simple answer, but there is a general principle that can be used to guide the allocation of savings among several options. Your overall strategy should be to maximize your cumulative after-tax return on investment (ROI), as this will maximize the amount of money available to spend on your goals. This is done by allocating the savings first toward the savings vehicle or debt service that has the greatest net financial impact. This is done as follows:

  • Calculate ROI. Determine the after-tax return on investment for each savings vehicle.
  • A Penny Saved is a Penny Earned. Note that making extra payments to reduce the principal balance on a loan that doesn't have a prepayment penalty could be considered as having a tax-free return on investment that is equal to the loan's interest rate. (If you deduct the loan interest on your income tax return, you need to reduce the interest rate by your marginal tax rate.)
  • Rank by ROI. Prioritize the allocation of savings according to the net return on investment associated with each option, targeting it first toward the options that have the greatest impact.

For example, if you are paying 13% on your credit card balances, and earning 3% on your savings account, paying off your credit card balances will save you 10%, tax-free. (This assumes, of course, that you will be able to resist the temptation to run up your credit card balances again.) Saving is not just about earning a return on your investment, but also about minimizing the amount you spend on interest servicing your debt.

If your employer matches employee contributions to their 401(k) accounts, the employer match should be considered part of your return on investment. However, while a 100% match may sound like a wonderful short-term return on investment, this return must be amortized over the number of years until retirement. For example, if retirement is more than 40 years in the future, the 100% match on the current year's contributions is the equivalent of adding 1.5% to 1.75% to the annual return. Depending on your anticipated return on investment and the number of years until retirement, this can increase your rate of return by a factor of 15% to 25% or more. The closer you are to retirement, the greater the relative increase in your amortized rate of return. (A good rule of thumb for calculating the additional annual return attributable to the employer match is that it will be at least 72 divided by the number of years until retirement and multiplied by the employer match percentage and at most 80 divided by the number of years until retirement and multiplied by the employer match percentage.)

The tax advantages associated with a Section 529 college savings plan are superior to those associated with a 401(k) or IRA. Contributions to a retirement fund earn a return on a tax-deferred basis. Contributions to a 529 plan not only earn money on a tax-deferred basis, but under current law distributions are also tax exempt when used to pay for qualified higher education expenses. Unfortunately, some broker-sold 529 plans charge high fees, which eat away at the tax savings.

This discussion yields a few good principles for allocating savings:

  1. Pay off high interest debt first. You are unlikely to be earning a return on investment from your savings that is close to the interest you are paying on your credit cards, so it is best to pay off your high interest debt first. (Be sure to include a letter to the lender with the extra payments indicating that the extra payments should be applied to reduce the principal balance of your loan. Otherwise, the lender may treat them as though they were an advance payment of future interest.)
  2. Maximize the match. If your employer matches contributions to your retirement fund dollar for dollar, contribute up to the limit of the match. The employer match is free money that effectively increases your return on investment by more than your marginal tax rate. This means that you are unlikely to outperform your retirement fund with other investments. If your employer offers only a 50% match, the match is not as valuable, and you should focus on other investment vehicles unless you are only 10-15 years away from retirement.
  3. Concentrate on Section 529 College Savings Plans. Section 529 College Savings Plans are among the most tax-advantaged savings vehicles available. If your state allows you to deduct contributions on your state income tax return, use your state's section 529 college savings plan. Otherwise, focus on the state plans with the lowest fees, such as those run by Fidelity, Vanguard or TIAA-CREF. You should aim to save the full cost of four years of college the year the student was born, which works out to be about one-third of anticipated college costs. Another third will come from current income and financial aid when the child enrolls in college, and the remaining third will come from future income in the form of low-cost education loans.
  4. Don't Default. Don't default on any debt, even if you can earn a better rate of return on other investments. Defaulting on your loans has very serious consequences that outweigh any potential return on investment advantages.

Recent college graduates who are trying to decide between paying off their student loans early or saving for retirement should use a similar analysis. The interest rate on federal student loans is usually low enough that it is better to contribute to your 401(k) and maximize your employer's match. However, private education loans often have higher interest rates, and so it may be beneficial to pay them off sooner. (If you decide to pay off your student loans sooner, and are currently using an alternate repayment plan, you may want to switch back to the standard ten-year repayment plan.)

Another potential consideration is the available time horizon. You might argue that children have more time available to pay off their education loans than the parents have to save for retirement, so the parents should put greater emphasis on saving for retirement. Plus, the parents might not be able to count on their children to help them if their retirement savings fall short. This approach says that you should take care of yourself first before helping your children. But you can also argue that one should save for the expense of greatest immediate necessity, namely college expenses. College expenses are more imminent, and you can't save for college after the fact. Given that it is cheaper to save than to borrow, shouldn't you focus on maximizing the overall return of your savings strategies? Borrowing to pay for your children's education while saving for your retirement might be penny wise and pound foolish. On the other hand, you can borrow to pay for a college education, but you cannot borrow to pay for your retirement (with the possible exception of reverse mortgages).

There aren't any easy answers to the tradeoffs between saving for college and saving for retirement. The decision often is based on philosophical differences as to who should pay for a child's education, the student or the parents. If you believe that the student should have primary responsibility for paying for his/her own college education, you will probably give greater priority toward saving for your retirement. This will force your children to borrow more for their education. If you believe that the parents have the primary responsibility for paying for their childrens education, you will probably put greater emphasis on saving for college. Regardless of who you believe has a greater responsibility for college expenses, you should at least consider the financial impact of each approach on total return on investment before making your decision.

 

 
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