A few weeks back, I was having a conversation with a co-worker who had the wise goal of “getting the most out of the benefits available” to employees at our company. That proclamation opened the door for me to poke my nose in.
me: “Are you getting the full 401K match?”
co-worker: “I’m contributing to the 401K.”
me: “Yes, but are you getting the full 401K match of 50% of the maximum 401K contribution?”
co-worker: “No, I haven’t, because we’ve been saving $700 per month into our two childrens’ 529 Plans.”
me (thinking to myself): hmm… 50% match versus 0% match?
me: “Well, that is admirable and responsible to look out for your childrens’ college costs, but what about looking out for you? That 50% match is like a guaranteed 50% market return, and you’re totally missing out on it! If it’s a cash flow issue, can you divert other funds to cover the income diverted to the 401K?”
co-worker: “Well, actually… I have some stock units that I have been sitting on…”
co-worker: <days later, after increasing 401K contribution to max> “I’m totally kicking myself for not realizing this sooner!”
Framing the question of “Should you save for retirement or college for your children?” in this scenario resulted in a fairly clear cut outcome. The savings were there to cover additional retirement contributions, while still being able to contribute to the 529 Plans AND there is a very healthy 401K match to gain, while simultaneously decreasing a dangerously high asset allocation to employee stock. That’s a grand slam!
But trying to decide if it makes more sense to save for retirement or college for children is not as clear cut with many folks. What if there is no 401K match or additional funds to access to cover both retirement and college savings? I mean, it’s your kid’s college, for F’s sake! What’s the alternative? They earn a scholarship? Or maybe they go to community college and take some responsibility by working throughout high school and college to pay off their education? Or maybe they end up getting their hands dirty as a plumber and make only $50 an hour after an apprenticeship? Hmm… ;-)
Here’s the thing – I think a lot of parents are scared shitless that if they don’t cover 100% of their kid’s college expenses, they will end up as some homeless drifter and as failed parents they will be ridden with crippling guilt for the rest of their days.
There’s no disputing that those with college degrees earn more, on average, than those without. And who doesn’t want to set their children up for success? Meanwhile, tuition inflation is out of control – the average annual cost of public school has increased about 10% even when adjusted for inflation. That’s potentially a huge debt burden for individual students and major student loan debt can be disastrous.
However, there’s also plenty of sentiment out there that kids may actually be better off if they earn it (or at least some of it). All kinds of research is popping up that shows privileged affluent suburban youth have higher rates of substance abuse, clinically significant levels of depression, anxiety, and physical ailments, and are more likely to steal from their parents than city youth with less money. Even if you’re rich, it may be more beneficial for your kids if you pretend like you’re not, even if it means they have to pay off at least a fighting share of their education.
At the same time, every dollar you divert to your kid’s unknown future is one less dollar you are diverting to your own. And average retirement savings are pitiful. We’re truly approaching a retirement crisis, and it is quite possible you will end up wandering the streets like a zombie, begging for high blood pressure and arthritis meds while reminiscing about Reebok Pumps, The A-Team, Trapper Keepers, and Mike Tyson’s Punch Out (or, maybe that’s just me?).
Those are the emotional arguments.
What about some tactical facts?
- Contributions to a 529 plan, prepaid tuition plan, and Coverdell ESA are not federal income tax deductible (they are similar to Roths). Traditional 401K and Traditional IRA contributions are tax deductible. So there are some obvious tax implications.
- Traditional 401Ks and Traditional IRAs are subject to a 10% penalty and taxation for early withdrawals.
- 529s, Coverdells, and prepaid tuition are also subject 10% withdrawal penalty (taxation is on gains only), if funds are withdrawn for reasons other than education. However, there are exceptions (scholarship, death, disability, etc.).
- Unlike with custodial IRAs for minors, prepaid Tuition, 529 Savings Plans, and Coverdell ESAs are all managed AND owned by the account creator and you can typically transfer beneficiaries, if you’d like.
- If it’s a “this or that” situation on contributions (limited funds), there is nothing preventing you from using a tax-advantaged 401K to save for your retirement and potentially pulling from it to help with your children’s college expenses. Since taxation and penalty would apply, you’d want to make sure the benefit of the company match outweighed the loss. Of course, more savings elsewhere so that you don’t have to do this and aren’t hit with taxes and penalties (while robbing your own retirement) is clearly a superior route.
- The federal need analysis methodology for financial aid considers both income (taxable and untaxed) and assets that are reported on FAFSA. Funds in qualified retirement plans, such as a 401Ks, 403Bs, IRAs, pensions, and some annuities, are not reported as an asset on the FAFSA application. Voluntary contributions from the taxpayer to these retirement plans during the base year (the prior tax year) are reported on the FAFSA and are counted as untaxed income. Employer matching contributions are not reported on the FAFSA. Untaxed income and benefits have a similar impact on aid eligibility as taxable income.
What’s the right answer? Retirement or College?
There is no right or wrong answer on whether you should save for retirement or your children’s college savings as each family’s scenario is going to be highly customized. And either way, doing either is a step beyond most – so give yourself a pat on the back and drop the guilt and fear!
Also, and I really want to emphasize this point: the PERFECT time to save for your retirement is BEFORE you have kids. Most younger workers put off saving for retirement in their early post-grad years, then the kids come and they don’t find the right time to save until 22 years later. Huge mistake, not only for the missed savings but also for the decades of missed investment returns. With the power of compound investment returns, every $1 saved in your 20’s is the equivalent of $10 saved in your fifties.
Personally speaking? Here are my thoughts for a guilt-free and responsible solution: I would grab my employer’s full 401K match first, and then would divvy up the remaining contribution allotments. I envision some sort of matching incentive program working very well to cover the practical, guilt, and privilege concerns noted previously, (e.g. “For every dollar you save throughout high school and college, I will match $2 in funds up to…”), particularly if you factor in a few years of community college and/or scholarships to keep costs down. Unless you’re really rolling in cash, can you really do much better than that?
What is your solution?
We opened up a Roth IRA for my daughter. She is 1 but there is no penalty to withdraw for education expenses or a down payment on a house. Also, if she does earn a scholarship or decides to not go to college, she will sill have a retirement account to continue investing in. We only contribute a little bit per year now but will increase after we open our own accounts.
The bigger downside with this is needing a larger amount to open the account.
This was a win/ win situation for us for our daughters education and future and think it is something more people should consider instead of the 529.
Mike, you should check that you’re using a legal investment vehicle for your daughter. I’m pretty sure your daughter must have earned income in order to contribute to a Roth IRA, which I suspect is unlikely at age 1.
You are correct Greg, you can only contribute as much to a Roth or Traditional IRA up to the amount the person made or 5,500 whichever is lower.
LOL. so i can’t open Roth IRAs for all my unborn great-grandchildren?? But the tax benefits!!!
This is unfortunately true. You’re better off opening a 529 for your child than an IRA for them. The tax benefits on a 529 can be better than the IRA depending on whether or not you live in a state where you can deduct the 529 contribution from your state taxable income.
“You’re better off opening a 529 for your child than an IRA for them.” I disagree. Open the Roth in your own name. You can use the principal to pay for your kid’s qualified education expenses and any earnings will remain tax free for your OWN withdrawal after age 59. I agree with G.E. that you should take advantage of any company match first. But once you’ve done that, the Roth gives you the most flexibility assuming you have the luxury of tying up additional funds. Unlike with the 529, if your kid doesn’t go to college, or gets a full ride, you have the Roth for your own retirement.
Currently I’m saving the max I can to my retirement accounts. When my kids are in college, I will just contribute the minimum to get the match (5%) and divert the rest to helping them with expenses. I have no plans to foot the whole bill for tuition, and I’m not sure why others think they must, even if they can’t afford it.
In the near future I may have to support two households of parents who didn’t save for retirement at all. The best thing I can do for my kids is save for my own retirement so they don’t have to support me. If I have extra to help with their expenses too, that’s a bonus.
I’m so glad you were able to help your co-worker realize his mistake and get him to contribute more to the 401K to get the full match. Even though I’m in debt, I still contribute enough to get my full employer match because hey, it’s free money!
I have no right solution. I’m a government employee so I’m hoping for a pension w/ SSA someday. But either or both of those might go away. Also, I have 2 or 3 kids that will someday be going to college. I contribute to my 457b but there is no matching at all. We’re thinking of putting our kids in private school and hoping they can earn enough to get all the scholarships to add up. I’m thinking of starting 529 plans.
You can borrow for college. You cannot borrow for retirement.
It baffles me how someone could chose to pay for college for their child if they cannot afford it. Your retirement is first and foremost, anything above that is an incredible gift to your child.
You know what? That’s a damn good, simple point.
Precisely why a Roth IRA is such a good solution. If college time arrives and you determine that paying for college could jeopardize your retirement, you keep the money in the Roth IRA . . .