One of the most difficult saving decisions is whether to save for retirement or for your child's college fund. College tuition has increased very quickly over the past decade and looks like it will continue to do so. All of us want the best for our children and a college education will be even more important in the future. If we can afford to save for retirement and a college education for our children at the same time, that would be ideal. However, many of us already have difficulties saving for retirement and it seems almost impossible to do both. Here's how to prioritize your retirement savings with your child's college fund.
Education is essential. As a parent, I believe a college degree is essential to compete in the future, and I would like to pay for the tuition if possible. I'd rather give my child a good education than leave an inheritance. My parents worked hard, paid for my education, and made it clear from the beginning that I won't get much of an inheritance.
Kids have more options. However, it is more essential to save for retirement first before saving for a college education. Your child will have a lot more options when it comes to college than you will for retirement. He or she can apply for scholarships and financial aid and can always take out a loan if necessary. There are also many ways to mitigate tuition costs, such as going to a community college for the first two years or attending a state college instead of a private school. Young people have a lot more options than retirees.
Expected family contribution. If you contribute to an education fund, it is best to avoid opening an account in your child's name. Twenty percent of a student's assets count as financial resources available to pay for tuition (your expected family contribution) and will reduce the amount of financial aid your child can receive. It is best to stash the college fund in a 529 plan. Here only 5.6 percent of the value of the 529 account is included in the expected family contribution calculation. The 529 withdrawal also doesn't count as income in the calculation and will not impact your child's financial aid amount in the future.
Retirement accounts. Retirement accounts such as a 401(k) or Roth IRA are not included in your child's financial aid calculation, so it is best to take full advantage of these accounts. If you have a choice between saving in an IRA or a taxable account, the IRA is the way to go because money in a taxable account will be counted toward the amount your family will be expected to pay for college. An IRA account also offers another way to pay tuition. You can withdraw funds from an IRA account to pay for higher education expenses with no early withdrawal penalty. However, it is best to avoid retirement account withdrawals until your child's senior year because the withdrawal will count as income and could decrease the amount of financial aid your child receives in future years.
The financial aid formula is very complicated and the percentages listed here are only an approximation. Parent and student income have the biggest impact on the amount of financial aid you could receive. If you have a lower income, then the student will have a better chance of receiving financial aid.
It is more prudent to save for your retirement than your child's college fund. You can't get a scholarship or a loan to finance your retirement. And money in your retirement accounts will not be counted when the student applies for financial aid, in addition to the valuable tax benefit you get by saving in a 401(k) or IRA. If retirement finances are already strong, then you can help with the college tuition or help to pay off the loans later as needed.
Joe Udo is planning an exit strategy from his corporate job by reducing expenses and increasing passive income. He blogs about his journey to early retirement at Retire by 40.
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