More parents are now thinking twice about using retirement savings to fund college dreams, and here's why their hesitation is warranted.
Most financial planners advise never tapping retirement savings to pay for your kid’s education. Even as college costs climb, there are still options to borrow that cash, whereas it’s often noted that you can’t borrow for retirement.
Yet about one-third of Americans with kids under 18 say they plan to use retirement savings or “could use if needed” to help pay for their children’s education, according to a recent survey by Sallie Mae, one of the nation’s largest student loan lenders.
The good news for retirement savings is that number is declining — in the 2016 edition of Sallie Mae’s survey, 39 percent of parents said they planned or may use retirement savings as a last resort to fund their children’s education.
More parents are now thinking twice about using retirement savings to fund college dreams, and here’s why their hesitation is warranted.
LOST RETIREMENT SAVINGS COULD HURT YOU
Paying for school from a tax-advantaged employer retirement account like a 401(k) can hurt you in several ways:
?A 10 percent tax penalty on early withdrawals below age 59½.
?A potentially bigger tax bill the year of withdrawal as the money you withdraw is counted as income.
?Loss of tax-free growth of your savings. Unlike taxable investment accounts, where you may have to pay the IRS annually for capital gains, employer-sponsored retirement accounts can grow tax-free.
?Less benefit from compounding. Early withdrawals will erode your portfolio’s growth potential.
But if you’re going to tap into your retirement savings, experts say the “least worst” option is to fund a Roth IRA . Unlike qualifying contributions to a 401(k) or traditional IRA, Roth IRA contributions aren’t tax-exempt. But as a result, there are also fewer restrictions on early withdrawals.
“You can withdraw any Roth IRA contributions that you’ve made without penalty,” says Crystal Wipperfurth, a certified financial planner with Bronfman Rothschild in Madison, Wisconsin. “This is not ideal, because it reduces your retirement savings, but it is an option.”
IT COULD HURT YOUR KIDS, TOO
Tapping your retirement savings can boomerang to hurt your kids if they need to provide financial help for you in your later years.
“We see clients want to help their kids through college at the expense of their own retirement, and we always advise against it,” says Matt Ahrens, a financial advisor at Integrity Advisory in Overland Park, Kansas. “Parents have to understand that sacrificing to help their kids through college may only put more stress on their children when they see their parents struggling financially in retirement.”
A more immediate blow: Using your retirement funds could hurt your child’s ability to qualify for student aid. Why? The cash is considered “ordinary income” and may put your total wages for the year beyond what qualifies for assistance.
Because retirement accounts aren’t counted when considering if a family economically qualifies, “funding your 401(k) or 403(b) is an advantage for college financial aid,” says Kimberly J. Howard, a certified financial planner with KJH Financial Services in Newton, Massachusetts.
Cash them out, and that exclusion goes away.
A 529 PLAN IS THE BEST WAY TO SAVE
More Americans tuck college savings into ordinary bank accounts (45 percent) than a 529 savings plan (29 percent), according to the 2018 Sallie Mae survey. But 529 plan investments have much more earning potential than an ordinary savings account, which often grows less than 1% a year.
“Parents of young children should start a 529 fund right away, and add money every month. Every little bit helps, and it will have the advantage of years of compounding,” Ahrens says.
“The first savings a family should make should be into their retirement account at work in order to get their company match. Then the remaining savings can be split between retirement — either at work or into a Roth IRA — and a college savings plan, like a 529 plan,” says Derek Hagen, a certified financial planner with Hagen Financial in Minnetonka, Minnesota.
This article was provided to The Associated Press by the personal finance website NerdWallet . Kevin Voigt is a writer at NerdWallet. Email: email@example.com . Twitter: @kevinvoigt.
NerdWallet: Retirement calculator – How much do you need to retire? https://nerd.me/retirement-calculator
NerdWallet: What is a Roth IRA? https://nerd.me/what-is-roth-ira