One of the toughest financial dilemmas parents can face is how toprovide for both their children's college education as well as theirown 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 startsaying: 'We have to do everything we can to help this child,'" says TomMuldowney, a financial planner in Rockford, Ill. So right away theystart putting money into a college account, either cutting back on orpostponing building their retirement savings. As a result "people whosave aggressively for their kids' education often do not have enoughmoney 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 isunderstandable. But it could backfire. According to Muldowney, whatmany parents often don't realize is that they may be able to providemore for their children's college education by saving money inretirement accounts, rather than putting it into education accounts.The rationale lies in the fine print of the rules that governretirement- and education-funding systems and accounts. (For moredetails on higher-educations costs, see the College Board's Web site.)
Tale of two familiesFirst, take a look at the student financial-aid rules. Parentsof a student who wants to receive a federal loan or scholarship mustsubmit a Free Application for Student Aid (FASFA), which requiresinformation about their income and financial assets. Based on thisfinancial data, the government calculates an Expected FamilyContribution (EFC), beyond which the student will require additionalfinancial aid. (Details and sample FAFSA forms are available in anonline guide.)In making this calculation, the government doesn't considermoney in retirement accounts, such as 401(k)s or IRAs. But it doescount the value of taxable accounts as disposable income that'savailable for the child's education expenses. What's fair game? Anybasic brokerage account, mutual fund, and, of course, college savingsaccounts such as the state-sponsored Section 529 plans.Let's say Family A had saved $100,000 for their daughter'seducation in a combination of savings accounts, CDs and 529s. Family Bput $150,000 into IRAs and 401(k)s. Neither family has any othersavings. So even though Family B has more money socked away, becauseit's in retirement accounts, their child will be eligible for morefinancial aid than Family A's child.Taking it outA second reason to save for retirement first lies in the rulesgoverning retirement accounts. No question, taking money out of an IRAor a 401(k) for any purpose other than retirement is usually a badidea. If you're younger than 59 1/2, you usually must pay a 10 percentpenalty to the IRS when you withdraw money from either a Roth IRA or atraditional one, and you'll lose the benefits of compounding growth. Ifthe withdrawal comes from a traditional IRA, you'll pay income tax aswell.
Paying for college can be a exception to this rule, however.Uncle Sam allows you to escape the early-withdrawal penalty for moneyfrom either a traditional or Roth IRA a long as you don't withdraw morethan you're spending that year on your child's higher education.As for 401(k) accounts maintained by your employer for yourretirement, you can't withdraw money for college costs without paying apenalty to the IRS. But you are allowed to borrow from such accounts,so those savings can also be tapped to pay for higher education ifnecessary. In effect, you pay your own retirement account back withinterest. For the rules on taking money out of retirement accounts, seeIRS 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 childcould receive aid.Spreading it aroundSo how do you follow the rules to provide the most benefit toeveryone in your family? Mary Ann and Stan Armstrong of Smithville,Mo., learned some lessons about this recently when they sought advicefrom Todd Shepherd, a financial planner in Leawood, Kan."I knew we didn't have anywhere nearly enough saved either forretirement or college," Mary Ann explains. Yet she had recentlyreceived an inheritance from her father. Mary Ann, 45 and Stan, 48,have two children, Sean, 8, and Noah, 3. Mary Ann, a nurse, doesoccasional part-time work but mostly stays home with the children. Stanis production manager of a food-processing company.
Shepherd's advice to the Armstrongs: Put as much as possibleinto retirement accounts, but continue to make small monthlycontributions to Missouri Most, the state-sponsored higher-educationplan, so that they can feel they're not neglecting the children'seducation.Cash flow countsIn general, Shepherd suggests, parents trying to save for thefuture "should ensure their retirement needs are met, then try to savesome in a tax-advantaged educational savings vehicle, and expect tofund some educational expenses out of their current cash flow, taxableaccounts, or Roth IRAs." His point about cash flow is important. In theArmstrongs' case, Mary Ann plans to return to full-time work, sothey'll have more income in the future.Many parents are likely to be at their earning peak when theirchildren are in college, and they should be able to afford to pay someeducation bills from cash flow. And if parents are retired or almostretired when the kids matriculate, they may be able to use IRA money orborrow from their 401(k) without paying early-withdrawal penalties.So how much will you need to save in retirement accounts ifyou may want to tap them for higher education as well as forretirement? I asked Muldowney to make a very conservative calculation.Here's what he came up with for a hypothetical couple: Two years beforetheir son Tommy is even a gleam in their eyes, our couple startscontributing $300 per month to their retirement accounts. They continueto do so for 20 years, receiving an 8 percent annual return -- untilTommy is ready for college.
Constantly changingWhen Tommy starts college, our couple's retirement account isworth nearly $178,000. While he's in school, mom and dad stop makingcontributions and withdraw $12,500 each for four years to help him withschool expenses. Yet, through the magic of compound interest, assuminga continuing 8 percent return for those four years, their account willstill be worth $181,176 when young Tommy graduates. Then his parents uptheir retirement contributions to $500 per month until they retire, 15years later.At that point -- again, assuming an 8 percent return -- theirretirement account will be worth a very respectable $773,310. (Thisexample does not account for paying income tax on the withdrawalsbefore age 59 1/2.)The rules for both retirement and education accounts can morphat any time. Just look at all the changes in tax law enacted byCongress and the White House over the last three years. But WarrenMcIntyre, a financial planner in Troy, Mich., says keep this in mind:"There are many ways to pay for college. However, with retirement, youget just one chance. If you have neglected retirement funding, youcould be out of luck in the future."Smart couples will pay heed, and adjust their portfoliosaccordingly.From Business Week
Source: Money & Work
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