JUNE 26, 2003
YOUR RETIREMENT
By Ellen Hoffman
A Lesson in Saving for College | Thanks to obscure savings-plan rules, the best way to finance your kids' education may be to sock away money in your own retirement account
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One of the toughest financial dilemmas parents can face is how to provide for both their children's college education as well as their own golden years. All too often, parents stash the bulk -- if not all -- of their savings in college accounts, say many financial planners.
"Parents take a look at a newborn infant, and they start saying: 'We have to do everything we can to help this child,'" says Tom Muldowney, a financial planner in Rockford, Ill. So right away they start putting money into a college account, either cutting back on or postponing building their retirement savings. As a result "people who save aggressively for their kids' education often do not have enough money for themselves at retirement," he says.
With annual college costs routinely running anywhere from $10,000 to $25,000 and more, the push to save for education is understandable. But it could backfire. According to Muldowney, what many parents often don't realize is that they may be able to provide more for their children's college education by saving money in retirement accounts, rather than putting it into education accounts. The rationale lies in the fine print of the rules that govern retirement- and education-funding systems and accounts. (For more details on higher-education costs, see the College Board's Web site.)
TALE OF TWO FAMILIES. First, take a look at the student financial-aid rules. Parents of a student who wants to receive a federal loan or scholarship must submit a Free Application for Student Aid (FASFA), which requires information about their income and financial assets. Based on this financial data, the government calculates an Expected Family Contribution (EFC), beyond which the student will require additional financial aid. (Details and sample FAFSA forms are available in an online guide.)
In making this calculation, the government doesn't consider money in retirement accounts, such as 401(k)s or IRAs. But it does count the value of taxable accounts as disposable income that's available for the child's education expenses. What's fair game? Any basic brokerage account, mutual fund, and, of course, college savings accounts such as the state-sponsored Section 529 plans.
Let's say Family A had saved $100,000 for their daughter's education in a combination of savings accounts, CDs, and 529s. Family B put $150,000 into IRAs and 401(k)s. Neither family has any other savings. So even though Family B has more money socked away, because it's in retirement accounts, their child will be eligible for more financial aid than Family A's child.
TAKING IT OUT. A second reason to save for retirement first lies in the rules governing retirement accounts. No question, taking money out of an IRA or a 401(k) for any purpose other than retirement is usually a bad idea. If you're younger than 59 1/2, you usually must pay a 10% penalty to the IRS when you withdraw money from either a Roth IRA or a traditional one, and you'll lose the benefits of compounding growth. If the withdrawal comes from a traditional IRA, you'll pay income tax as well.
Paying for college can be a exception to this rule, however. Uncle Sam allows you to escape the early-withdrawal penalty for money from either a traditional or Roth IRA a long as you don't withdraw more than you're spending that year on your child's higher education.
As for 401(k) accounts maintained by your employer for your retirement, you can't withdraw money for college costs without paying a penalty to the IRS. But you are allowed to borrow from such accounts, so those savings can also be tapped to pay for higher education if necessary. In effect, you pay your own retirement account back with interest. For the rules on taking money out of retirement accounts, see IRS Publication 590, "Individual Retirement Arrangements," at www.irs.gov. If your savings were in education accounts instead of IRAs or a 401(k), you would have to spend them to pay the college bills before your child could receive aid.
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Copyright 2003, by The McGraw-Hill Companies Inc. All rights reserved.
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