When families start thinking about how to pay for their child’s education, whether it’s primary, secondary, or college, the options can feel overwhelming. Many think of this as college planning, but it can extend to any stage of education, depending on your family’s philosophy.
One of the most common questions we get from young families is, "How do we save for education?" The answer is that there are three primary ways to approach it: pay now, pay then, or pay later—or a combination of all three. Here’s what that means.
- Pay Now
Paying now means setting aside money from your current income into a savings or investment vehicle to cover future education costs. This allows you to build up a fund in advance, often taking advantage of tax-advantaged accounts. The idea is to give your savings time to grow and be ready when the education bills arrive.
Traditional funding options for paying now include:
- 529 Plans: One of the most popular choices for education savings. Contributions grow tax-deferred, and withdrawals for qualified education expenses are tax-free. These plans are flexible and can be used for various education costs, including tuition, room and board, and even K-12 private schooling in some cases. Many states also offer tax deductions or credits for contributions.
- Coverdell Education Savings Accounts (ESAs): Similar to a 529, Coverdell accounts allow for tax-free growth and withdrawals for qualified education expenses. However, they have lower contribution limits and more restrictions, but they can be used for elementary and secondary school expenses as well as college.
- Custodial Accounts (UGMA/UTMA): These accounts allow you to save and invest for your child under your name until they reach the age of majority. While they don’t provide tax advantages like a 529 or ESA, they offer more flexibility in terms of how the money is used, even beyond education. However, these assets are considered the child's, which may impact financial aid eligibility.
- Roth IRA: While traditionally a retirement account, Roth IRAs can be used to save for education. You can withdraw contributions at any time without penalty, and earnings can be withdrawn for qualified education expenses without an early withdrawal penalty, although taxes may apply.
- Savings Bonds: U.S. savings bonds, such as Series EE or I bonds, offer a safe way to save for education. Interest earned is tax-free if used for qualified education expenses, provided certain income limits are met.
Each of these options has its own pros and cons, and it’s important to consider what works best for your family’s financial situation and long-term goals. Using a combination of these savings vehicles can also provide flexibility in how you allocate funds over time.
- Pay Then
In this approach, you pay for education out of your cash flow when the time comes. Rather than saving in advance, you handle the costs as they arise, adjusting your budget as necessary to cover tuition or other education-related expenses.
- Pay Later
Paying later typically means borrowing money to cover education costs. This option spreads the financial burden over time but comes with added interest and the potential for long-term debt. However, for many families, borrowing is a necessary part of funding education, and there are various options available to help manage these costs.
Traditional borrowing options include:
- Federal Student Loans: These are loans offered by the U.S. government and are often the first option families consider for paying later. Federal loans come with fixed interest rates, flexible repayment terms, and the possibility of loan forgiveness for certain professions. For undergraduate students, these include:
- Direct Subsidized Loans: These are need-based loans where the government pays the interest while the student is in school.
- Direct Unsubsidized Loans: Available to all students, these loans accrue interest while the student is in school, but repayment can be deferred until after graduation.
- Parent PLUS Loans: These are federal loans available to parents of dependent undergraduate students. They typically have higher interest rates than student loans, but they allow parents to borrow up to the total cost of attendance minus any other financial aid. Repayment usually begins immediately unless deferred.
- Private Student Loans: Offered by banks, credit unions, and other financial institutions, private loans can help cover costs that federal loans don’t, though they tend to have higher interest rates and fewer borrower protections. Private loans are typically based on creditworthiness, so interest rates and terms vary widely.
- Home Equity Loans or Lines of Credit (HELOC): For families who own a home, tapping into home equity can be a way to fund education expenses. These loans use your home as collateral, and interest rates are typically lower than unsecured loans. However, using home equity to pay for education can put your home at risk if you’re unable to repay.
- Retirement Plan Loans: Some families consider borrowing from their retirement savings, such as a 401(k), to fund education expenses. While this option allows you to borrow from yourself, it can be risky because it reduces your retirement savings and can incur penalties or taxes if not repaid promptly.
- Institutional or School-Specific Loans: Some colleges and universities offer their own loan programs to help students and families finance education. These loans may have more flexible repayment terms and lower interest rates compared to private loans, but availability and terms vary by school.
- Federal Work-Study Programs: While not a traditional loan, work-study allows students to earn money through part-time jobs, which can help reduce the need for borrowing. This program is based on financial need and provides students with opportunities to work while attending school, often in campus jobs related to their field of study.
Combining Borrowing with Other Strategies
Many families opt to combine borrowing with saving and paying out of cash flow to minimize the overall debt burden. By borrowing only a portion of the cost, you can reduce long-term interest payments while still spreading out the financial responsibility over time.
Combining the Approaches
Many families find that using a mix of all three methods works best for their situation. You can save a portion of the cost upfront, pay out of cash flow when necessary, and borrow to cover any remaining expenses. This flexible approach allows you to spread out the financial responsibility and adapt as your circumstances change.
Family Philosophy: Start Here
Before deciding on an approach, the most important step is to define your family’s philosophy.
- How much of the cost are you planning or willing to fund?
- What will you pay for: college, graduate school, tuition, room and board, books, food, car, gas, etc.?
- Can your child choose any school, or are there limitations (public vs. private, in-state vs. out-of-state)?
- How many years of education are you anticipating?
- How many children are you supporting, and will their needs differ?
- Are there other sources of financial support for your child, such as contributions from grandparents, extended family, or others?
- Are you or your children expecting financial help from other relatives or family members?
- Do you plan to support your child in other ways, such as paying for travel, internships, or study abroad programs?
- Will your financial contribution impact your retirement or other long-term goals?
These questions are just the beginning and will shape how you proceed. There’s no one-size-fits-all approach, and your financial plan should align with your values. Beyond these, there are many more factors that can influence your decision, and it’s important to take a holistic view of your family’s situation when planning for education.
The Bottom Line
The right way to save for your child’s education depends on your family’s goals and circumstances. Whether you decide to pay now, pay then, pay later, or use a combination of the three, the key is flexibility and planning. Having a clear philosophy will guide your choices and help you allocate your resources effectively. No matter which method—or mix—you choose, what matters is that you’re preparing for the future in a way that makes sense for your family.
Mark J Modzeleski, CFS, CLTC, AIF
President, Legacy Wealth Advisors of NY