College Cash From Your Retirement Stash
The old advice was simple: Stash cash for college until your kids graduate, then save like crazy for your own retirement. When 50-year-old empty-nesters who could look forward to hefty corporate pensions were the rule, that counsel worked pretty well.
Look around a PTA meeting today, though, and you'll see lots of parents who've gone gray long before their kids learn multiplication tables. For today's 40-plus parents, college savings compete directly with building a retirement nest egg. So, many financial advisers recommend combining those goals: Pack your savings into retirement accounts, using the tax breaks to help pay for both your kids' education and your golden years. "Put college money in a 401(k), and you'll end up with more for college and more for retirement," says Jeffrey Feldman, a planner at Rochester (N.Y.) Financial Services.
While the tax code makes it easy to build big balances in an individual retirement account (IRA), 401(k), or similar plan, tapping those funds for tuition takes ingenuity. College aid, too, can rise or fall based on where you stash your savings. But with enough planning, parents--especially those who'll be in their mid-50s or older when Junior gets a bachelor's degree--can make retirement accounts serve two purposes.
PROJECTIONS. First, a word of warning: Don't even think about using retirement funds for education if paying college bills will leave you short for your retirement. Suppose you need $12,500 a year, starting at age 48, for college. That $50,000, plus taxes and a 10% early-withdrawal penalty, will cost your 401(k) $90,909--and cut your income by $27,300 every year after you retire. "You've invested in your child's future by sabotaging your own," says Dee Lee of Harvard (Mass.) Financial Educators and co-author of The Complete Idiot's Guide to 401(k) Plans (MacMillan General Reference, $17.95).
So your first step should be a retirement-plan checkup to see if you're saving enough. If your employer's benefits office can't run your numbers, go online, to calculators at FinanCenter (www.financenter.com/retire. htm) or Investors Guide (www.investorguide.com/retirement.htm). Software such as Quicken Financial Planner can do more detailed projections.
Once you're set for retirement, you can look at our numbers to see where to stash extra savings for college. Let's say you're putting 6% of your $80,000 salary in a 401(k) to max out your company's match. You figure you can save an additional 4%--$3,200 a year before taxes, or $2,080 aftertax--toward college. You can put that in your 401(k), a Roth IRA, or a tax-efficient stock index fund. Assume all the accounts earn 10% before taxes. The charts show what you'll have left if you start saving when your child is 6 or 12 and cash out--paying taxes and penalties--when he or she is 18.
Older parents get a break. If they're 59 1/2 when they start to withdraw, they net the most with a 401(k) or Roth IRA. (Under the 1997 tax law, any IRA can be used without penalty at any age to pay college expenses--a good reason to funnel kids' income from jobs into deductible IRAs. But the Roth IRA's big break--tax-free earnings--isn't available until age 59 1/2.)
The next best choice is a tax-efficient index fund in your child's name. If you set up a custodial account under the Uniform Gift to Minors Act, you'll have to endure the "kiddie tax" until your child turns 14. The first $700 of your child's investment earnings will be tax-free, the second $700 will be taxed at 15% (10% for capital gains), and the rest will be taxed at your top rate. After children turn 14, they file their own returns; then, they can protect $4,250 in earnings from tax. An account started for a 12-year-old escapes tax altogether--matching the 401(k)'s performance--while an account with more time to grow gets nicked. The downside of a custodial account: You surrender control of the cash when your child reaches 18 or 21.
Tapping a 401(k) or a Roth IRA before age 59 1/2 is expensive. You'll pay a 10% penalty (plus tax) for early 401(k) withdrawals. Even so, a 401(k) might outperform a taxable account if you have longer to save or if your non-401(k) funds generate more taxable income than this hypothetical index fund. Investing in a Roth IRA is the worst choice if you'll need to withdraw earnings early.
None of this takes into account another "tax"--one imposed by college financial-aid formulas. Many middle- and upper-income parents assume they won't qualify for aid. In fact, a family with one college-bound student can often get tuition help if it has income below $125,000 and modest assets, says John Roche, a certified financial planner and aid specialist in Hartsdale, N.Y. With two or more kids in school, "it's hard not to qualify," Roche says.
LOAN STRATEGY. A 401(k)-based college fund is a mixed blessing at the financial-aid window. On the plus side, the formula for federal (and most state) aid doesn't expect you to spend retirement assets on college. If you've earmarked $50,000 in your 401(k) for college rather then setting up a separate account, you can qualify for $3,000 more federal aid. But suppose you draw $12,500 from your 401(k) to pay first-year bills. When you apply for sophomore aid, that will show up as income--and mean about $3,750 less aid.
So how do you tap your 401(k) or IRA with the least consequences? With a 401(k), you can take a loan: 75% of employers let savers borrow half their 401(k) balance, up to $50,000. But experts frown on 401(k) loans because they slow your fund growth. Such loans must be repaid fast: If you borrow $12,500 a year, by the time Junior's a senior, you'll be shelling out $11,000 in annual payments. And 401(k) loans have a doomsday feature: If you leave or lose your job, your loans are due in full immediately.
A smarter strategy is to borrow elsewhere. A home-equity line of credit, with a 15-year term and tax-deductible interest, is the best deal. Banks also offer a federally subsidized package called PLUS--Parent Loans for Undergraduate Students--to help parents pay their share of college costs. PLUS loans last 10 years, with interest capped at 9%.
Wait a minute--what's the point of borrowing if you've spent years building a college fund inside your 401(k)? In high-finance terms, you're using a "bridge loan"--funds to tide you over until it's cheaper to tap your retirement account. If you're in your 50s when your child enters college, you can use a home-equity loan to pay your share of school bills. Sure, you'll pay interest--but it will cost less than what your 401(k) funds can earn. And you can start tapping your 401(k) to pay off the home-equity loan after you turn 59 1/2 with no penalty and no financial-aid hit.
That strategy won't work for everyone. Your 401(k) plan may not allow large enough contributions to build both a retirement kitty and a college fund. Your house may already be leveraged to the hilt. Psychologically, you may need the comfort of seeing separate accounts for education and old age. But with a double savings challenge looming before you, it might be hard to overlook the extra oomph that 401(k)s and other retirement accounts can bring to your net worth. True, you'll need some financial skill to tap the funds. But an extra dose of wisdom is one of the advantages older parents can bring to the party.