Saving for Competing Desires: Your Child’s Education vs. Your Retirement
We often find that there is a desire to save for the competing goals of our children’s education and our retirement. Planning for higher education costs can be tricky because, while it is wise to start saving when your child is young, there are several unknown factors during this time that make estimating college costs challenging. For example, if your daughter is eight years old, it would be ideal to start saving for her college education now instead of when she is sixteen and you have a better idea of how much it will cost. When she is older, she may show promise of receiving an athletic scholarship or maybe she has a passion for a major only offered at an out-of-state school. Alternatively, she may decide to pursue an opportunity that does not even require a college degree, thereby defeating the purpose of all your diligent saving! While these factors give us a clearer idea of how much to save, waiting until you know all of these answers will put you at risk for not having enough saved when it is time to send your child off to college.
To avoid not having enough, we try to save early on. Typically, it almost always seems better to have too much saved rather than too little for any financial goal, but 529 plans can present a unique issue by saving too much. Like many tax-advantaged investment vehicles, 529 plans have their pros and cons. 529 plans are great because your after-tax contributions grow tax-free with distributions for qualified higher-education expenses also tax-free. However, they are restricted in that tax-free distributions only apply to qualified higher education expenses, and can only be used for the beneficiary’s higher education expenses, even if they end up not needing all of the funds! In the event that your 529 plan is overfunded, you have two options: either rename the beneficiary to someone who is a family member of the original beneficiary or withdraw the remaining funds and incur a 10 percent tax penalty on the earnings in addition to ordinary income taxes. The risk in contributing too much to a 529 plan comes down to “locking up” the funds because of the restrictions and penalties associated with using the proceeds for anything other than qualified higher education expenses.
This common scenario leads us to why Yeske Buie believes in splitting up education savings into different investment vehicles. In general, we think it is ultimately advantageous to allocate about 50 percent of your estimated education savings needs into the 529 plan, with the remainder going to other investment vehicles. This strategy allows you to keep your planned education savings invested, but mitigates the risk of putting too much in a 529 plan in the event that you end up not needing all of the funds.
An example of a strategic way to safely fund both your retirement and your child’s education is to split contributions between a 529 plan and your Individual Retirement Account (IRA). While IRAs have a host of their own restrictions, there is a provision that allows you to make distributions before age 59 ½ for qualified higher education expenses without being subject to the 10 percent penalty. The advantage of this strategy is that if your 529 savings are enough for your education expenses and you do not need to dip into your IRA, and your IRA savings are still there for your retirement without being subject to penalties. In other words, your IRA can act as a “back-up bucket” to fund your child’s education costs while keeping you from overfunding the 529.
Another great advantage of a 529 plan is that if your child receives a scholarship, you can make a qualified distribution for non-educational expenses up to the amount of the scholarship. This distribution will not be subject to the 10 percent penalty, but it will still be subject to ordinary income tax on the earnings. For example, if your daughter receives a soccer scholarship for $20,000 that covers her tuition, books, fees, and room and board, she may still need money for a computer, transportation, and other needs that are classified as non-qualified educational expenses. You are permitted to take a distribution of up to $20,000 that can be used for her expenses that will not be subject to the 10 percent penalty, but will be subject to ordinary income taxes. This is yet another advantage of a 529 plan that allows your child to take advantage of scholarships without defeating the purpose of your diligent savings.
Remember, there are no scholarships for retirement! By avoiding overfunding your 529 plan, you keep from overusing retirement savings to fund higher education costs that can change depending on several factors. Fortunately, proper financial planning can help you manage the balancing act of giving your children a valuable college education without neglecting your own retirement.