If you have savings and/or investments on which to draw, you might consider using these funds to pay your child’s private school or college tuition bills as they come due.
A savings account can be a typical savings account at a bank or a money market account. There are several advantages to paying education bills from your savings.
First, withdrawing from your savings account is simple. For one thing, no independent approvals are necessary (except perhaps from your spouse). You simply go to the bank and withdraw as much money as you like. In addition, there are no tax implications or penalties associated with such withdrawals, so you won’t have to worry about complicated tax calculations come tax time.
Second, savings accounts generally earn the lowest rate of return as compared to other investments, so you don’t have to worry about missing out on high returns. This is referred to as low opportunity cost.
Third, if you have enough savings, you can avoid tapping into your retirement accounts, something most planners recommend avoiding if possible. Similarly, the more savings you use, the less money you (or your child, if college age) will need to borrow. Borrowing increases the cost of private school or college because you must pay back principal and accrued interest. By contrast, when you use your savings to make education payments, you avoid interest payments.
The disadvantage of using your savings is that the more funds you deplete, the less available money you will have for emergencies. It is generally recommended that you keep at least three to six months of your salary in a savings account for emergencies. In addition, using a large portion of your savings to pay education bills may mean postponing other purchases like a new car or furniture.
Investments can include more common items like stocks, bonds, and mutual funds or more obscure items like real estate investment trusts and precious metals. Liquidating your investments (i.e., converting them to cash) is also a good way to pay current education bills. Most investments are easily liquidated (though it may take a few days to get your check in the mail or to have funds transferred to your checking account) and do not require an application or other approval.
However, liquidating investments is a bit more complicated than simply withdrawing from your savings account. First, if you have several different investments, you need to choose which investment(s) you want to liquidate. Factors you should consider here are the rate of return that each investment is earning, your asset allocation, the prospects for each investment in the coming year, and which investment will generate the most capital gain (or loss) if sold. Your financial planner can help you determine which investments may offer the best benefits if liquidated.
In addition, liquidating investments can mean a small headache come tax time. When you do sell an asset, make sure to keep track of the number of shares sold (if appropriate), how long you have held the asset (if the asset sold was a capital asset, then any holding period over 12 months will result in long-term capital gain), your tax basis, the sale price, your profit (or loss), and any accompanying paperwork so that you can properly document the transaction on your tax return.
In some instances, parents may choose to gift an asset (such as stock) to their child and have the child sell it. The benefit is that the child generally pays capital gain tax at a lower rate.
How can you increase your savings and/or investments?
Some parents may not have sufficient funds in their savings account today (for example, when their child is a college freshman) but would like to build up their reserves to pay education bills a couple of years down the road. If so, this money needs to be accumulated gradually through savings.
Systematic savings is a structured method of accumulating money in which you save by “paying yourself first.” This means setting aside something from each paycheck as soon as you get it rather than saving whatever is left at the end of the month. You must stick to your savings plan to make it work, and you may have to make sacrifices in other areas, but systematic savings can be an excellent way to boost your savings account so that you have a reserve of funds to pay tuition bills in future years.
The first step is to determine how much money you can save out of each paycheck. If your employer offers payroll deduction, you may want to consider this option because it is less difficult to part with money that is taken directly from your paycheck. As you accumulate money for education bills, you may want to place your savings in an investment vehicle that protects the principal. Because of the relatively short-term nature of your goal (i.e., less than five years), the stock market may not be an appropriate choice. Instead, you may want to consider a savings account, a money market fund, or a certificate of deposit timed to mature when you are ready to pay a tuition bill.
How do you know if this strategy is right for you?
Most parents probably draw off their savings and/or investments at one time or another to pay their child’s private school or college bills. So the real question is probably how much of your savings and/or investments you should expend.
The answer depends on several factors, primarily the amount of your savings, your expected income needs in the next couple of years, your expectations about maintaining your current lifestyle, your monthly expenses and emergency fund requirements, and the current cost of borrowing. For example, if you want to retain the comfortable lifestyle to which you are accustomed (i.e., nice vacations, new cars), then you will need to leave a bigger savings cushion than if you are willing to budget for a few years. As for budgeting, in addition to accounting for regular monthly expenses (e.g., car payments or their own student loans), parents must also try to anticipate other one-time expenses, such as braces for Junior or a new roof for the house.
Other factors that parents of college-bound children may want to consider are how much (if any) they expect their children to contribute to college costs. Some parents expect their children to take out student loans in order to have a greater stake in their education. If so, parents can use less of their own savings. In addition, parents may want to estimate the amount of financial aid their child will receive (if any) in the upcoming year. If your child wins a scholarship in his sophomore year that will cover part of the following year’s costs, you can adjust any withdrawals from savings and/or investments accordingly.