In most households, retirement and college savings are at the top of the priority list of financial plans. Many parents ask if it is possible to pay for their kids’ college education and still afford to retire comfortably. Conventional wisdom tells parents to prioritize their retirement savings before helping their children. This idea is supported by the notion that one can borrow for college, but not for retirement. In the end, parents may have to work a little longer than they had planned, and their children may have to borrow a little more money than they would like. It’s important to remember that through a well-constructed and a disciplined savings plan both goals can be achieved.
The first step to any successful long-term savings plan is to start early; time is on your side. Ideally, one should start saving for retirement with their first earned paycheck. College savings should begin the moment the little bundle of joy arrives. Delaying can have major negative impacts on the savings outcome. However, for young adults, the lack of disposable income coupled with the long-time horizon for both events creates a lack of urgency to start these savings plans.
The common features in both retirement and college savings plans driving these unique growth opportunities are tax-deferral and compound interest. Unfortunately, few appreciate the value of compound interest, which is what Albert Einstein called the “eighth wonder of the world.” The physicist said: “He, who understands compound interest, earns it…he who doesn’t…pays it.” The chart illustrates how $600 annually can generate over $73,000 in 30 years through the power of compounding creating four times the amount invested.
Retirement Savings Strategies
Employer Sponsored Retirement Plans – If you have access to a 401(k) or 403(b) plan through your employer, it makes sense to contribute to the plan as a priority. In addition, if the employer matches employee contributions, take full advantage and maximize the employer match on contributions. It will be the best return on investment that you will ever earn. These plans do have a contribution limit. For employees under the age of 50, the limit is $18,500 per year. Employees age 50 and over can add an incremental $6,000 per year as a “catch-up” contribution. In addition, as long as you do not take distributions from these accounts during the child’s college years, these assets will not affect your child’s financial aid prospects.
Individual Retirement Account – Roth and Traditional IRA’s are great instruments to put away extra savings for retirement. There are contribution limits. Individuals under age 50 can deposit $5,500, if they are age 50 or over, they qualify for the catch-up provision, which increases their limit to $6,500. Contributions may be tax deductible under certain conditions.
In addition to retirement funding, IRA’s can be a secondary source for college funding. Tax laws have been amended to allow IRA withdrawals for qualified higher education expenses without incurring the 10% penalty for distributions before age 59-½. Traditional IRA withdrawals are subject to income tax. A Roth IRA may be the better choice since the withdrawals of the Roth contributions would be tax and penalty free. Keep in mind that distributions will count as income on the following year’s financial aid application and can reduce eligibility. In addition, if the IRA was planned to play a major roll to supplement retirement, once the money has been withdrawn, it cannot be put back.
College Savings Strategies
529 Plans – If parents are in a position to put away funds specifically earmarked for higher education, the preferred way is with a 529-college savings plan. These plans are operated by the states and are designed to give families a tax break. Contributions to these plans grow tax-deferred and the withdrawals are tax-free as long as they are used for qualifying education expenses. Some states offer state tax breaks on contributions. These plans do come with some drawbacks. First, withdrawals made for non-education expenses are subject to income taxes and a 10% penalty. Additionally, money saved in 529 plans are factored into financial aid eligibility.
Financial Aid – It’s important that a student has access to as much financial assistance for college as possible. However, just because financial aid options are available, does not mean they should be used in every instance. For example, you should compare the interest rates and fees you would be charged on the loan to the returns you earn on your investments. If the charged interest rate were higher than your investment returns, you would be better off minimizing the loan amount. More information about federal financial aid can be found at https://fafsa.ed.gov/.
Scholarships and Grants – Parents and their children need to make it a mission to search for scholarships. To start, parents should check with their own workplace or companies with whom they do business. For example, their property + casualty insurance company may offer scholarships. There are also companies designed to assist with the search. Scholarships are offered through many local and national organizations, such as churches, endowments, service organization, municipalities, and colleges themselves. Increasingly, colleges are offering means-tested scholarship for low income families.
Community College and Commuter College – Living at home and attending a community college for the first two years of a four-year degree program to earn core college credits can amount to worthwhile savings. Also, choosing a four-year institution that is close enough to home to commute can drastically reduce the cost a college education.
Everyone wants the most comfortable retirement they can afford, and the best head start for their kids. Just remember that you don’t want to support your children through college only to risk becoming a burden to them in your retirement years. Do the best you can. Children will be just fine with or without your help. Helping your kids evaluate costs versus benefits is a form of education that will aid in the decision-making process the rest of their lives.
Dan Krstevski, CFP®