An important consideration for your savings should be for your or your children’s education. Some people look to handle this using a 529 savings plan. If you decide to finance your children’s education this way, don’t sacrifice saving for your retirement at the expense of funding a 529 plan. You can take a loan out for education; you cannot take a loan out for retirement!
529 plans can vary from state to state. You can research 529 plans at an excellent website, SavingForCollege.com. The vehicle is similar to a Roth IRA in that you use after-tax money to fund it, but your earnings are tax exempt.
One of the downsides of 529 plans is that the earnings portion of money from a 529 plan that is not spent on eligible college expenses will be subject to income tax and an additional 10% federal tax penalty as well as the potential of having your return any state tax deductions or credits you may have taken.
The 529 account is an asset that may affect your child’s eligibility of financial aid (loans and grants). If the parent or student owns the 529 account, then the college financial aid office will only take into consideration 5.64% of the entire value for calculating expected family contribution.
I will encourage my children to place their money in an IRA or Roth IRA when are at the age where they begin to work – even odd jobs after school. The reason for this is that the value of an IRA (for both parents and children) cannot be used to negatively impact eligibility for educational financial aid, however, it cannot be used for education (unless they plan to go to college when they are 59 and a half years old.)
Some of you are probably thinking that your children (or really, you) should be able to have the money available to pay for college costs when they are 18 rather than making your children responsible for a large education loan. Let’s take a look at the cost difference between using a 529, or taking the money and invest in a Roth IRA.
Eighteen years from now (say 2028) when your newborn turns 18, you decide to send them to a public college. You will need to save $105,000 to pay for 4 years of tuition and fees assuming a 2010 yearly cost of $7000 and a tuition inflation rate of 7%. For a private college or university you will need about $320,000. Let’s stick with the public college option for our estimates.
The annual contribution limit for a 529 college savings plans is set by the federal gift-tax exclusion limit. As of 2008, the current limit is $13,000. If you are married, your spouse may elect to split the gifts made to purchase a tuition certificate for a beneficiary, thereby doubling the amount of the annual gift tax exclusion—from $13,000 to $26,000. The question here is, “can you afford to save $26,000 or even $13,000 a year above your own retirement account contributions. Actually, you dont have to. With a monthly payment of $251 with an estimated rate of return of 6%, you will have saved the $105,000 needed for the 4year public college for one child. If you have dreams of sending the one child to a private college, expect to contribute 800 to 1000 monthly – coming close to meeting the federal limit. Remember that this is for one beneficiary, so if you have more than one child you expect to send to college, you may not be able to save enough.
Instead think about starting your child off with their own Roth IRA. Usually you can have one set up when they rach some working age – say 14. If you take that same $250 a month (starting when they are 14) until they can afford to pay that themselves, by the time they reach 65, they will save $2,010,976.39 over 51 years. If they up their yearly amount to $5000 (above their 401K) when they are employeed, that number will be greater. Any earnings on a Roth IRA are tax exempt.
If your child chooses not to go to college, you have options:
- You can leave the account open for future use—for up to 30 years (so maybe your grandchildren can benefit)
- You can change the beneficiary to another “member of the family,” within the federal 529 rules—even yourself!
- You can also take a refund adjusted for fund performance (a penalty on your investment).
There is no right or wrong answer – just an answer that you feel comfortable with.
Consider also doing both. You may also weigh the costs to you for funding the 529 for 10 to 18 years as well as putting your children on the path to a comfortable retirement by teaching them to invest early in an IRA or Roth IRA. One of the things you need to look at is how the contributions to a 529 plan affect your ability to save for your own retirement. You may think it is selfish to think of yourself before your children’s education. Loans may help to build their credit rating portfolio. Saving for yourself first does provide you with a comfortable retirement making you less of a burden on your adult children, plus you can leave the gains you make with your own investments as a legacy for your children instead of your investments going to a college or university.
As an older dad, I will be turning 60 when my oldest graduates from college in 2022. If I feel so generous, I can certainly help her and her two younger siblings from either my wife’s IRA or my Roth IRA.
I would say that much of what I invest now toward my kids is time. I help to focus their growing minds on some things and expand them for all things. Perhaps, if we are lucky, a scholarship is in the realm of possibilities for all of them. If not, perhaps a government paid education at the U.S. Merchant Marine Academy catches their interest.