Can You Afford Private School Tuition Costs?
I was recently asked by a local media outlet to comment on the costs of private school tuition. Wes suggested that I share these thoughts with the broader blog community, as it might be helpful for those faced with the decision of education costs.
How to Determine if You Can Afford Private School
When people think about educational expense, the first number they consider is often how much they make. But we often think about salaries in pre-tax terms. People think, “We make a combined $250K per year, so $30K for private school seems doable.” But the effect of taxes is huge.
Some (extremely) rough math. Let’s say private school is $29K per year per kid (for early grades, maybe 3rd-5th). This expense requires after-tax money. Today, the marginal federal rate for a $250K salary range is 33%, and PA is ~3%, which combine for a ~36% tax rate (ballpark). This equates to a ~$45K yearly pre-tax salary requirement – for each kid! ($45K salary – 36% tax (of $16K) = $29K). If you have 2 or 3 kids, pretty soon we’re talking real money. Clearly, a private school education can eat up a lot of your pre-tax salary very quickly.
Paying for private school for several kids based on this income, and no savings, is probably not going to work in the long run, especially since these expenses change over time. While our assumed grades 3-5 yearly expenses are $29K, private high school is closer to $35K per year. So school gets more expensive as the kids get older. Additionally, there is inflation in education generally. So the $29K and the $35K are inching up in parallel every year, AND the kids are moving into the more expensive educational cost brackets as they age. So you have 2 factors working against you.
And What About College Tuition?
Now for the big whammy: college. College can be an expense that is an order of magnitude greater than for high school. For instance, ivy league tuitions are closing in on $50K per year, and with housing, food and books, that could climb to $65K. So, assuming you choose a private college as well, you are looking at a step-function jump in expense as the kids transition to college.
Another reason to consider college financing early: Do you want to pay a bunch of money for private high school, exhaust your savings, and then have your kid come out of college in debt? My personal opinion is this is not a good idea, although some may disagree. Some might argue that you should spend a lot on private high school, in order to get into a good college, and then the kid can leave a good college in debt, but with bright career/earning prospects. The idea might be then that the kid’s enhanced earning power would more than offset the debt repayment requirement. Personally, I would question this kind of thinking. I say target a debt-free graduation from college, if possible. The point here is that you can’t think of high school in a vacuum; you must consider it in the context of financing college as well.
Because educational expenses are so high it can be a challenge to finance them purely out of your salary. But let’s say you have an alternative source of capital: you’ve got some after-tax money saved up. Let’s say you have $250K. You can use some portion of your after-tax salary, and finance the balance of the education expense by drawing down this $250K in savings over time. If you’re doing very well, you might even be able to contribute to it while financing private school.
You probably don’t want to leave this savings nut in cash in your mattress, since if it grows, and/or generates some income, you will draw down the principal more slowly for education expense than otherwise. Obviously, accessing the principal more slowly would be desirable. Likewise, you probably don’t want to invest it in risky over-the-counter derivatives. Losing a big piece of it early on is not desirable. You need to find some level of risk you are comfortable with, which will allow you to meet your future educational expense, but also protect you from a permanent loss of capital that would derail your ability to keep paying for private school.
By now, everyone has heard of 529 plans. These tax advantaged vehicles provide various tax benefits for those saving for college. At the federal level, your investments grow tax deferred, and distributions for college are tax free. Within PA, contributions are deductible. These can be a useful tool in your educational financing strategy. If you are younger parents, you can fund a 529, make ongoing contributions, and use that capital as a block for financing college.
In general, for investing money that will be used some day for educational expenses, we like to focus on the FACTs. F) Fees, and expense ratios should be as low as possible. A) Access to your capital is key. Seek liquid public markets, and avoid hedge funds, or private equity, which reduce access. C) Complexity: avoid esoteric strategies that you don’t understand. T) Taxes are critical for taxable accounts. For taxable accounts, avoid mutual funds, which distribute taxable gains, and opt for ETFs instead, which defer taxable gains via the in-kind creation/redemption process.
Additionally, some people are heavily invested in the companies for which they work. This reduces overall portfolio diversification; if your company does poorly, you may be forced to sell stock at just the wrong time. By owning stock while also having your human capital (since you work there) at the firm, if the firm goes bankrupt, you could get doubly hurt. Think of Enron and its employees who had their life savings invested in Enron stock when it went bankrupt and they were laid off.
Above all, you want to be conservative about how quickly these savings can reasonably be expected to grow. Equity markets and bond markets alike are expensive today, and there is a strong case to be made that future returns will be lower than they have been historically. We think a 4% to 5% real return in today’s expensive markets would be a pretty good outcome. Yet many still think in terms of double digit nominal returns, which they may have seen in the past.
So what you can do with a financial planner is look at your expected future salary and anticipated increases, and any after-tax savings and 529 plans, and work backward into your expected educational expense, and how quickly will consume and overwhelm these resources. Ok, so you can’t afford 12 years of private school. What about 6? You can reverse engineer your plan. Based on your income, how much you have saved, and your projected educational expense, you can triangulate into a number of years of private school you can afford, under reasonable assumptions. Next you can stress test your projections to see what happens under various scenarios. What if your savings grow very slowly? What if your salary grows slowly? What if your savings take a 10% or a 20% hit due to adverse market conditions, if your salary takes a similar hit, or you hit a stretch of unemployment? What happens if education inflation is higher than you anticipate? How likely/unlikely are these and are you comfortable with these risks?
For many the answer is going to be to defer your private school expense, until such time as your salary and savings can safely cover the remaining school years, with a buffer in case your savings take a hit, you lose your job, or education inflation is extreme.
And this all should take place within the context of your overall portfolio. You also want to have some money set aside for emergency funds. You want to contribute to your retirement. Maybe you want to fix up the house. You want to be able to service your mortgage. A financial planner can help you create a roadmap that takes into account these various considerations.
Some Rules of Thumb
Although every situation is unique, people love rules of thumb. So here are a couple. If you have combined income of $200K, a $600K mortgage, and $200K in savings, then it may be financially aggressive to put your 2 kids into private school when they’re in 1st and 3rd grade. The math in the later years just gets ugly. However, if you have combined income of $300K, a $400K mortgage, and $500K in savings, and your kids are in 4th and 6th grade, then perhaps this is more realistic. Of course this depends on your assumptions, the schools you pick, your lifestyle tastes and longer term financial goals. Speaking of mortgages, the yield on the 30-year treasury hit an all time low recently, so it may be a good time to consider a refinancing.
Finally, don’t forget your own biases. It’s easy to be overconfident. Overconfidence is a well-developed human bias, and while you are often totally unaware of it, it can have significant long-term consequences for financial planning. You may overestimate your salary growth, the stability of our job, or how quickly you can grow your savings. Then there is the planning fallacy, which describes how, when planning for the future, we tend to be overly over-optimistic about how long things will take, how much things will cost, and future risks. Know that you may suffer from the planning fallacy, and be accordingly more conservative. In the end, you might need to consult an independent financial advisor to help you work through these issues.
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