With all the hand-wringing over runaway college costs and recent college graduates struggling under the weight of more than $1 trillion in student loans, it's no wonder that some new parents start worrying about paying for college even before their babies can walk.
But sometimes the best intentions aren't the best solution.
Research shows many parents are making the mistake of saving for college while ignoring the need to save for retirement. In addition, parents invest college savings so poorly, they are undermining the meager sums they are stashing away.
In one of the latest national studies on parent priorities, 52 percent of parents told researchers it's more important to save for their children's college education than for their own retirement. About one-quarter of the parents surveyed by MarketTools Inc., on behalf of T. Rowe Price, said paying for college keeps them awake at night.
In the best of all worlds, parents would save for college and retirement. But if cash is short, retirement needs to be the priority, because small savings when parents are young will do more for their future than trying to catch up later.
For example, a 20-year-old who stashes about $20 a week into a stock market index mutual fund in a retirement savings plan like a 401(k) or individual retirement account, is likely to end up with about $1 million by retirement. But a person who waits until 45 to start saving would have to save about $245 a week to accumulate the same amount. That's $12,750 a year.
If you are saying to yourself: "Who needs $1 million?" consider that inflation over a lifetime will make that $1 million buy much less than it will today. In about 30 years, $1 million will seem more like today's $400,000. Perhaps $400,000 sounds like a lot. But given that you might live 25 or 30 years after retirement, that sum will provide only about $16,000 a year for living expenses.
So starting to save on a first job is crucial, even though teens and people in their early 20s recently told researchers for TD Ameritrade they are inclined to put off saving for retirement until paying off college loans, buying a car and buying a house. That's a prescription for disaster.
Before committing to cars and homes, young families should consider retirement savings a necessary first expense. If house payments won't allow you to save for retirement, home expectations need to be ratcheted back. As a rule of thumb, it's wise to save 10 percent of pay for retirement every year.
That might leave little available to save for college, but a student can get loans to help pay for college. And a parent who has saved adequately for retirement can temporarily use more of their paycheck during their child's college years to cover college costs. Parents should realize they won't qualify for loans for groceries at age 70.
Because college savings might be limited, getting the most from them is crucial. Yet, 44 percent of parents in the T. Rowe Price survey said the "best way" to save for college is in a savings account.
You'd be hard pressed now to find a savings account paying even 1 percent in interest. If parents of a newborn committed $100 a month to such an account, they might accumulate about $22,000 by college -- far short of the $162,000 that four years at a public university is likely to cost. For a newborn, a balanced mutual fund would make more sense because it combines stocks and bonds — perhaps growing 7 percent a year on average and producing $39,000 by college.
Of course, any fund that combines stocks with bonds can suffer losses. For example, in 2008, such a fund would have lost about 29 percent before recovering two years later. So for a child two or three years from going to college, an account like a savings account is sensible. But even then the best choice isn't a simple savings account at a bank or credit union. Rather, pick what's called a 529 college savings plan. These are offered by states, and anything you save in them is free of taxes if the money goes toward college. As a result, more of your savings works for your child rather than being taxed as in a typical savings account.
If you pick a 529 plan based on your child's age, stocks and bonds will help grow the money when the child is young, then as college nears investment choices will be safer, similar to a savings account.
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