Build Wealth: Live With Your Parents Until Age 26

I can imagine that regardless of whether you are a parent or a young adult, you will read this title and immediately exclaim “Absolutely not!” (Or something . . . similar to that in meaning). I regularly hear rants from parents that once their kid turns 18 they are “out on their own.” When I ask why 18, they tend to say “because that’s when I left my parent’s house.”

The problem with this logic is that it is rooted in a period of time (the 1970’s), where education costs were largely subsidized by state taxes, funding 75% of the total cost of education with just 25% being funded by students and their families. Today, that ratio is flipped – only 23% is funded by states. Meanwhile, according to CNBC (November 2021), “college costs have increased by 169% over the past four decades – while earnings for workers between the ages of 22 and 27 have increased by just 19%.”

As Yogi Berra famously said, “The future ain’t what it used to be.” Times have changed, the rules of the game have changed, and so we must change with it if we want to win, if we want our kids and families to win in the long run. The good news is that there is a different way to look at all of this that can setup our kids turned young adults with a terrific foundation from both a career and financial position.

I would like for you to consider the following idea. Suppose there was a plan that would give your student the following by age 26:

  • A bachelor’s degree, entirely free of debt with no loans taken out ever
  • A Roth IRA with a value potentially over $70,000
  • An HSA (Health Savings Account) with a value potentially over $46,000
  • A high-yield savings account with more than $46,000

The catch: You have to allow your student to live in your house rent-free. The student will need to have about $3,000 in cash savings to cover the end of the first year before they receive their tax return.

At this point, for a number of people I am certain your interest is at least piqued, but there likely is some skepticism involved, and there should be. After all, who is going to pay for all of this and make all of this happen. And how is it even possible?

Here are the simple answers to those questions, followed by lengthy explanations on how this works and a Q&A at the end.

  1. Parents are going to continue supporting their student by not charging them to live there. That means being able to enjoy not having to worry about paying a landlord ever-rising housing prices and utilities on top of that.
  2. The student will pay for everything else by working full-time, going to school part-time online. From food and phone to tuition and health insurance, working full-time will cover those expenses.

How This Works

The Internal Revenue Code, or IRC, contains a number of different tax credits designed to support lower-income individuals. These tax credits are designed to subsidize the cost of health care, education, and retirement savings. However, in order to qualify for these programs, the individual must satisfy the following requirements. (I have shortened these to the most relevant requirements).

Premium Tax Credit (PTC)

  • Enrolled in health insurance coverage through the Marketplace, meaning that the employer does not offer qualifying health insurance.
  • Cannot be claimed as a dependent by another person (a person must have over half of their support provided by someone else for the year, which won’t be the case here)

American Opportunity Tax Credit (AOTC)

  • Be pursuing a degree or other recognized education credential
  • Be enrolled at least half-time or at least one academic period
  • Not have claimed AOTC more than four tax years

Lifetime Learning Credit (LLC)

  • Paid qualified education expenses for higher education
  • Paid to an eligible institution (any college, university, trade school, or other post-secondary educational institution eligible to participate in the U.S. Department of Education student aid program)
  • You cannot take both the AOTC and LLC at the same time; this credit is much lower and will be used in years 5-8 of the plan

Saver’s Credit

  • Age 18 or older
  • Not claimed as a dependent
  • Not a student (but student here specifically means enrolled full-time)
  • On-the-job training courses and schools offering courses only through Internet are NOT included.
  • Must have an AGI < $20,500 to receive the full 50% credit up to $1,000 annually.
  • This is a 50% credit of contributions made to the Roth IRA up to $2,000 contributed.

I am assuming that the student working full-time will earn $15 an hour, 40 hours a week, 50 weeks a year with two weeks of unpaid time off. This would amount to a total salary of $30,000, which you will notice is above the Saver’s Credit AGI. However, there are a number of deductions that can take place that will reduce the student’s AGI considerably, including the following:

  • Health insurance premium. If an employer does not provide minimum essential coverage (MEC), the health insurance premium from a plan paid for in the Marketplace is tax deductible.
  • By purchasing a Silver-level plan, it is likely that the plan satisfies the requirements of a High Deductible Health Care Plan, or HDHP, thereby allowing the student to contribute to a Health Savings Account (HSA). Funds in an HSA can not only be saved, but invested, and are carried over from year to year with no requirement to use them at any point.
  • This plan flexes in a little bit of contribution to a workplace 401(k), but could easily just mean the student working less hours to lower their income under the $20,500 AGI threshold needed for the full Saver’s Credit. The student could also contribute part of their funds to a Traditional IRA instead of a Roth IRA as a means of manipulating the AGI under the $20,500 threshold.

Below, I have modeled a student making $15/hour, working 40 hours per week, 50 weeks per year with two weeks of unpaid holidays. The assumptions for the Silver-level plan premium come from Townsend’s July 2022 article detailing estimated health insurance premiums through the Health Insurance Marketplace. I have assumed a 6% state tax rate based on AGI, 3% inflation on both salary and expenses, and I am assuming that the IRS tax tables will reflect at least a 3% inflation adjustment for the Saver’s Credit, which they did do this past year.

With respect to the tax credits, the Saver’s Credit is non-refundable, meaning that if the student’s tax liability is $0, it will not give them a refund. However, the AOTC is partially refundable (up to $1,000) and the PTC is fully refundable. The student should ask their employer not to withhold any Federal payroll taxes at all so that they can take full advantage of the non-refundable and partially refundable credits, which will maximize what they get back (yes, a refund I kid you not) in their tax return. With those credits paid to the student, they will net on average over $5,000 a year after paying all expenses, including tuition.

Finally, assuming a 10% annual rate of return on the HSA and Roth IRA, not adjusted for inflation, and a 3% annual return on the high-yield savings account, at age 26 the student will have accrued over $46,000 in the HSA, $72,000 in the Roth IRA, and $46,000 in cash savings. In today’s dollars, that would put the student in the 94th percentile with respect to net worth. By the time the student reaches age 65, assuming a 10% rate of return not adjusted for inflation, the student would have nearly $2 million in the HSA and $3 million in the Roth IRA – and this assumes they stop contributing to those accounts after finishing school. However, if they continue to contribute to both accounts, by the time they reach age 65 those accounts could be greater that $3.5 million and $5.5 million respectively, with the HSA funds being tax-free for qualifying medical expenses and the Roth funds being entirely tax-free upon withdrawal. The chart below extrapolates until age 75, assuming no further contributions nor withdrawals are made with either account after age 65.

With a faster paced and ever-increasingly competitive global economy, we need to realize that our children, our students are competing with other people not just from our town or city or state, but with people all over the country and around the world. Coupled with significantly longer life expectancies, our children will need both deeper skills and deeper financial resources to have a solid foundation to build a life upon. We may not have all the resources to just freely give away, but we can provide an environment and the time needed to work with our children, now young adults, to meet these challenges together. I believe that through this plan, from an education standpoint and from a financial standpoint, the 26-year-old that emerges from this will have all the resources and skills needed to tackle an uncertain world.

And that, in my opinion, is truly preparing our children for the future.

Questions & Answers

Why use a Roth IRA as opposed to a Traditional IRA or increased 401(k) savings?

With a student at this income level, their effective Federal tax rate is 8.03%. This is likely far less than they would pay in income taxes if they used a tax-deferred account, deducting the contribution, but then being required to paid income taxes on required minimum distributions starting in their seventies. Roth contributions are after-tax, meaning that income tax has already been paid on these dollars, but the principal and growth are tax-free on withdrawal.

By the time the student gets to their seventies, this account could be in excess of $5 million, meaning that their first required minimum distribution would be approximately $200,000. Additionally, because of the tax credit scheme we are using, the taxes that would have been paid are being absorbed by the various tax credits – the student after credits has no federal tax liability. Would you rather pay 0% tax on $6,000 or approximately 26% tax on $200,000?

What if my student does not plan to attend a formal college?

Attending a trade school can still potentially qualify the student for the AOTC and LLC educational credits. Depending on the nature of the apprenticeship or training, they may still qualify for the Saver’s Credit, and if their employer does not provide health care that meets minimum essential coverage, they can purchase a Silver Plan and have almost the entire premium credited back to them. Combined with the income deduction, the health care coverage is practically free.

What if I want to contribute to my student’s educational costs? Can I still do that?

You absolutely can! You can directly pay the institution for your student’s tuition and it is not considered a gift under the estate tax and gifting rules nor is it considered income.

What if I want to accelerate this process and finish sooner? Do I really have to take this long?

Not at all – this is meant to be an example of how to approach the problem and to demonstrate how the various credits and tax deductions work. You can modify this to fit your approach, but keep in mind that some of the numbers, such as the Saver’s Credit and PTC, will be affected based on your AGI. The higher the AGI, the lower the benefit received by these programs. For example, if you are just $1 over the $20,500 threshold for the Saver’s Credit in 2022, the credit reduces from 50% to 20%, reducing the credit by $600. Games can be won or lost in inches; in this case, a single dollar can make a big difference!

What if the student’s employer does provide health care coverage that meets MEC?

The student will both not qualify for the Premium Tax Credit and will not be able to take their health care premium as a deduction. What this mostly affects with respect to the plan is the AGI of the student, so watching how it affects that calculation is the most sensitive part. While the PTC is the only fully refundable tax credit, the math works out such that the Saver’s Credit and AOTC with its partial refundability (up to $1,000) would still be fully utilized. The nature of the plan changes, but mostly still holds up even if the employer provides health care coverage.

What if the employer does not offer a 401(k)?

You can reduce the Roth IRA contribution by the 401(k) amount and put that into a Traditional IRA, generating the offset necessary to lower the student’s AGI to the Saver’s Credit threshold.

Why is AOTC not the full $2,500 in the first couple of years of your model?

Because in the first two years, there is slightly more than $1,000 in tax credits between the Saver’s Credit and AOTC, so a slight amount of the partially refundable AOTC doesn’t get realized.

Why is Taxable Income listed separately in the graphical?

Because it is needed as part of the calculation required for federal tax, but is not double-counted. Look, I did my best to keep this as clean for you, the reader as possible, but it was just easier to stick it there when building the model. Let me have this one, alright?

References

Hess, A. J. (2021, November 2). College costs have increased by 169% since 1980—but pay for young workers is up by just 19%: Georgetown report. CNBC. Retrieved August 8, 2022, from https://www.cnbc.com/2021/11/02/the-gap-in-college-costs-and-earnings-for-young-workers-since-1980.html

Townsend, R. (2022, July 27). How age affects health insurance costs. ValuePenguin. Retrieved August 7, 2022, from https://www.valuepenguin.com/how-age-affects-health-insurance-costs

Want to discuss how these changes may impact your personal situation? Schedule a free consultation and let’s talk about whether you should be concerned and what to do about it.

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