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Financial Planning for New Parents (Part III: Save for the Future)

June 14, 2013

As life starts to settle back into a normal routine following the arrival of your child (granted this might take a year or so), your attention will likely turn to the daunting matter of funding his or her education. Beyond the pure need to stash away dollars, there are a myriad of educational savings alternatives to choose from. You also need to keep your retirement savings on track so your son or daughter won’t need to support you during your golden years.

Saving for College

According to a recent College Board report1, the average cost to attend a private four-year college was over $40,000 for the 2012-13 school year. Assuming a 5% inflation rate on college expenses implies a cost in 18 years of nearly $100,000 per year, or $400,000 for a 4-year stay. In-state public schools are about half as expensive. Fortunately, as college costs have continued to increase, so has the availability of grants and scholarships to help lighten the load.

As with saving for any goal, the earlier you start the better. The power of compounding returns works wonders: $10,000 earning an 8% return over 18 years turns into $40,000. But before you start socking away money, take some time to select the right type of account to facilitate your savings. Analyzing all the options for education savings can get complex. I will hit on a few of the more common approaches:

Use a tax-advantaged education savings account. There are several different types of accounts allowing tax-free earnings if the money is used for education expenses. For example, if you contribute $10,000 today, and the investments grow to $40,000 over the next 18 years, you can spend the entire $40,000 on educational expenses without owing taxes on the $30,000 in investment gains. Depending on your state of residence and tax situation, this savings could be well over $10,000.

Probably the two most common options are 529 Plans and Coverdell Education Savings Accounts (ESA). Although these accounts both allow tax-free withdrawals, they have a few differences:

  • Coverdell Education Savings Accounts (ESAs) allow you to invest in almost any security, much like a normal brokerage account. Contributions are capped at $2,000 per year and eligibility to contribute is phased out for taxpayers with high income. Another benefit is the ability to use funds for K-12 educational expenses such as private school tuition and needed supplies like a computer.
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  • 529 Plans are popular plans that allow larger contributions, but investment options are usually limited. Since plans are sponsored by individual states, each state’s plan is a little different. It is important to know that you don’t need to use your home state’s plan, nor does your child need to attend college in the state that sponsored the 529 Plan. Some states offer an income tax deduction on contributions, which can make a 529 particularly attractive. Program fees charged to administer 529 Plans generally make these plans slightly more expensive than similar investments in an ESA.

Save for your child’s education using a Roth IRA. This is a strategy that has gotten a fair amount of press recently. The logic being you can take a penalty-free withdrawal of contributions from a Roth IRA to pay for qualified educational expenses. Hence, this approach allows you to grow money tax free without it being allocated to education. If the funds aren’t used for college, you still have the money growing tax-free for your retirement. Here is the rub: there are limits to how much you can contribute to a Roth IRA (and income limits on eligibility). If you can fund a Roth IRA, you should be using this vehicle to save for your retirement as much as possible (see retirement discussion below) and another account for education expenses.

Open a custodial account in your child’s name. By opening an account in your child’s name you can reap many of the tax savings (due to child’s low tax bracket) without the restrictions. There are no contribution restrictions (beyond regular gift tax limits) and the money does not need to be spent on education. One downside is loss of control by the parent. Once you have funded a custodial account, the money must be spent for the child’s benefit and the money becomes theirs-to do with as they please-once they reach age of majority.

Saving money in your child’s name may also impact his or her eligibility for college financial assistance. Federal rules assume a far greater amount of a child’s assets are available to pay for educational expenses than the parent’s assets.

Of course, you can also save for college using a standard, taxable account. Clearly, this is the simplest option. The negative is that you are giving up potential tax advantages. The impact depends on your individual situation and how you invest the money outside a tax-sheltered account.

Saving for Retirement

Although funding your kid’s education may seem like a more pressing need than saving for your own retirement, your family will be well served by making sure that your retirement is on track before committing dollars for college. This may seem counterintuitive given that college expenses are “only” 18 years (or less) away, and you don’t plan on retiring for perhaps another 30 years.

Putting retirement savings first is simply a matter of alternatives. There is no alternative for funding your retirement. No one is going to loan you money, give you a grant, or award you a scholarship to fund your retirement. If your savings fall short, you will either need to get by with less in retirement or continue working past your desired retirement age. Conversely, there are many ways to pay for college. Beyond attending a lower cost school to reduce the burden, there are federal loan programs, grants, part-time jobs, and scholarships to help provide funding.

Although you clearly want to avoid loading your child up with student loans, it may be a better option than sacrificing your own retirement aspirations and perhaps saddling them with the cost of your care when your savings run out in retirement.

1 College Board’s Trends in College Pricing 2012