A Lesson in Saving for College

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-educations 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 percent
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.

Spreading it around

So how do you follow the rules to provide the most benefit to
everyone in your family? Mary Ann and Stan Armstrong of Smithville,
Mo., learned some lessons about this recently when they sought advice
from Todd Shepherd, a financial planner in Leawood, Kan.

"I knew we didn't have anywhere nearly enough saved either for
retirement or college," Mary Ann explains. Yet she had recently
received an inheritance from her father. Mary Ann, 45 and Stan, 48,
have two children, Sean, 8, and Noah, 3. Mary Ann, a nurse, does
occasional part-time work but mostly stays home with the children. Stan
is production manager of a food-processing company.

Shepherd's advice to the Armstrongs: Put as much as possible
into retirement accounts, but continue to make small monthly
contributions to Missouri Most, the state-sponsored higher-education
plan, so that they can feel they're not neglecting the children's
education.

Cash flow counts

In general, Shepherd suggests, parents trying to save for the
future "should ensure their retirement needs are met, then try to save
some in a tax-advantaged educational savings vehicle, and expect to
fund some educational expenses out of their current cash flow, taxable
accounts, or Roth IRAs." His point about cash flow is important. In the
Armstrongs' case, Mary Ann plans to return to full-time work, so
they'll have more income in the future.

Many parents are likely to be at their earning peak when their
children are in college, and they should be able to afford to pay some
education bills from cash flow. And if parents are retired or almost
retired when the kids matriculate, they may be able to use IRA money or
borrow from their 401(k) without paying early-withdrawal penalties.

So how much will you need to save in retirement accounts if
you may want to tap them for higher education as well as for
retirement? I asked Muldowney to make a very conservative calculation.
Here's what he came up with for a hypothetical couple: Two years before
their son Tommy is even a gleam in their eyes, our couple starts
contributing $300 per month to their retirement accounts. They continue
to do so for 20 years, receiving an 8 percent annual return -- until
Tommy is ready for college.

Constantly changing

When Tommy starts college, our couple's retirement account is
worth nearly $178,000. While he's in school, mom and dad stop making
contributions and withdraw $12,500 each for four years to help him with
school expenses. Yet, through the magic of compound interest, assuming
a continuing 8 percent return for those four years, their account will
still be worth $181,176 when young Tommy graduates. Then his parents up
their retirement contributions to $500 per month until they retire, 15
years later.

At that point -- again, assuming an 8 percent return -- their
retirement account will be worth a very respectable $773,310. (This
example does not account for paying income tax on the withdrawals
before age 59 1/2.)

The rules for both retirement and education accounts can morph
at any time. Just look at all the changes in tax law enacted by
Congress and the White House over the last three years. But Warren
McIntyre, a financial planner in Troy, Mich., says keep this in mind:
"There are many ways to pay for college. However, with retirement, you
get just one chance. If you have neglected retirement funding, you
could be out of luck in the future."

Smart couples will pay heed, and adjust their portfolios
accordingly.

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