The typical investor has two long-term goals: retirement and kids’ college expenses. Ideally, a family would estimate how much each will require, make a conservative guess about likely returns, and then invest enough each month to reach both targets on schedule.
But that’s tough to do. So which goal should come first?
“Retirement savings needs to outweigh college savings,” says David Hryck, a tax attorney and personal finance expert with the Reed Smith law firm in New York.
Though it seems harsh to pit the parents’ interests against the kids’, the kids have plenty of time to pay off student loans, while parents will have much less time to restore retirement savings raided for college. Kids can delay college to work and save, work while in college, go to a cheaper school or live at home, or even get college benefits from the military.
[See: 7 Stocks to Buy for the Baby Boomer Retirement Wave.]
“The biggest issue is the fact that you can borrow for college, whereas you can’t borrow for retirement,” says Oscar Vives Ortiz, a planner with First Home Investment Services in Tampa Bay/St. Petersburg.
And although many parents are willing to postpone retirement to pay for college, that’s not always an option. “Nearly a quarter of retirees were forced into retirement due to circumstances beyond their control,” says Roger Michaud, director of sales for the Franklin Templeton 529 College Savings Plan, citing a survey by his firm.
“Seniors ages 65 to 74 have nearly six times the amount of education debt now than they did 25 years ago,” says Roger Cowen, owner of Cowen Tax Advisory Group in Hartford, Connecticut, referring to a study by LIMRA, the life-insurance association.
“Many are taking on student loans later in life to help their kids or grandkids pay for college. Those in default on federal student loans are getting their Social Security payments garnished. It happened to 156,000 Americans in 2013. That’s three times more than in 2006.”
Parents should harness the impulse to sacrifice for kids by scouring the family budget for savings that could help boost college investments, says Coleen Pantalone, a finance professor at the D’Amore McKim School of Business at Northeastern University.
“Look at disconnecting from cable and using one of the movie options such as Netflix (ticker: NFLX),” she says. “Then look at your cell phone bill. Do you need all that data?”
Most experts warn against raiding retirement plans like 401(k)s to pay for college. Generally, a withdrawal before turning 59.5 will trigger a 10 percent penalty on top of income tax, wounding the account so badly it might never recover, and undermining retirement plans. While the IRS does allow hardship withdrawals for college expenses, qualifying can be difficult.
Parents can hedge their bets by investing for retirement with Roth 401(k)s or Roth IRAs, says Christopher Kimball, president of CK Financial Services in Lakewood, Washington. Contributions to Roth accounts can be withdrawn for any purpose without penalty or tax, though investment gains taken out before age 59.5 are taxed and penalized.
“If the child receives scholarships or decides not to attend college, the money stays in the Roth and can be used to help fund retirement,” Kimball says.
There would be no tax or penalty for taking a loan from a 401(k) account to pay for college. But that, too, could inflict long-term harm. A 401(k) loan means selling assets in the account, rather than just using them as collateral as the term implies, so you’d miss out on any gains those holdings could have enjoyed before the loan is repaid and the assets purchased again.
“401(k) loans generally have to be paid back within five years or taxes and penalties can result,” Kimball says. “This is not a good thing.”
[See: 15 Money Management Tips for College Students.]
While IRA money is not penalized if used for college, such a withdrawal would still be taxed and future investment gains would be lost, he adds.
Another option is to raid taxable accounts you’ve set up for retirement. You may face long- or short-term capital gains on profits, but there will be no early withdrawal penalty. Still, there would be a loss of potential investment gains and the risk of coming up short in retirement.
It’s also possible to take out a home-equity loan against the family’s primary residence to pay for college. Keep in mind that variable rates can jump after the initial teaser period.
Borrowing against the home, like raiding retirement savings, undermines retirement security by leaving the owner with less equity to extract in a downsizing or reverse mortgage.
For retirement savings, Hyrck urges sticking with the tried and true, such as investing at least enough in a 401(k) to get the maximum employer match.
“Do not pull back in favor of college savings as you will be leaving free money on the table,” he says.
To get the most from college savings, he recommends a Section 529 plan, where gains are free from federal tax, and often state tax as well.
Many families, he adds, should also consider the UTMA account, (Uniform Transfer to Minors Act), or the similar UGMA (Uniform Gifts to Minors Act.) These allow gifting to minors without incurring gift taxes, with subsequent investment gains taxed at the child’s usually lower capital gains rate.
These “custodial accounts” are an easy alternative to a more complex trust. Note that the money must be used for the child’s benefit and the child will gain control upon turning 18 or 21, depending on the state. These accounts can reduce the child’s eligibility for financial aid, since child’s assets weigh more heavily in the formula than the parents’.
Though many parents worry that saving for college will undermine eligibility for financial aid, experts caution against counting on grants or scholarships.
“The best way to get financial aid is to be broke or brilliant!” Kimball says.
“I find it frustrating that those who have worked hard, been responsible, and saved diligently for college are, in a way, punished because the money they saved can cause them to be ineligible to receive much of the financial aid available,” he adds. “Those who have squandered their money on big houses, boats, fancy cars, jewelry, etc. and are now broke as a result often get rewarded by receiving financial aid.”
[Read: 4 Kinds of Insurance That Can Save Your Retirement.]
Nonetheless, saving is the best option, most experts say, as squandering resources does not assure aid will be offered when the time comes. Even if financial aid is available, some or all may be in loans.
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How to Save For Retirement While Paying for a Child’s College originally appeared on usnews.com
