Can helping kids with college expenses risk your retirement?

Ralph and Sandy are hypothetical, typical American parents. They only want the best for their children. Now they are facing college tuition costs and the funds just aren’t there to meet that need.  What to do? They have considered tapping into Ralph’s retirement savings, but are concerned about the impact such a move might have on their own long term future.

Ralph and Sandy are not alone.  Costs for higher education have been skyrocketing for years at an inflation rate that can be dizzying. When other savings and investments have been tapped, it is only natural to look longingly at the bigger balance in a retirement account and think that might be a viable resource.  However, taking such a move might just backfire with unintended consequences.   Tapping into retirement savings early might just cost parents and their kids even more than the current price of a student loan. 

So, should you consider using retirement funds to help pay for your children’s education?  For most people, the answer is very likely NO, parents should not use retirement savings to pay for their kid’s college education.  Retirement savings are just that, retirement savings, funds earmarked for use later in life to support the parents in retirement. 

If these funds are used for children’s education, will the child be able to support the parents as they age? There are other options for funding an education and these should be considered first.  Using the parent’s retirement funds for children’s educational expenses is probably a funding source of absolute last resort.  Besides the long term retirement support consideration, there are potentially significant and rather expensive tax consequences.

For most people, retirement savings represent a body of money accumulated over time that is tax deferred.  In most cases, the original deposits into the retirement plan were made pre-tax, that is no income taxes were paid on those deposited earnings. All the investment earnings over time then accumulated without paying any income tax. If money is to be withdrawn from retirement accounts, every dollar withdrawn will be income taxed as ordinary income.  This means that any withdrawals will be added to the household income for the year and this may even push the parents into a higher tax bracket and cause the tax bite to be even bigger.

If the parents are under age 59 1/2, there is also a 10% early withdrawal penalty added on top of the income taxes due. Depending on the state in which the parents live and the total household income of the parents, this might mean as much as half of the withdrawal could go to taxes and penalties before getting to paying any educational expenses. This makes a retirement plan withdrawal have serious tax consequences that should be carefully considered.

So, if retirement funds are not a good resource for education funding, what should struggling parents like Ralph and Sandy do or consider as options?   Well, actually, there are several options to ponder. Sources of funding to consider before resorting to using retirement funds include student loans, parent loans, student employment, scholarship options, grants, work-study programs, and extended family help (such as grandparents, aunts, uncles, etc.)  One important step is to seek out the financial aid counselor at each school being considered.  People in these positions have access to information about a wide range of funding options and scholarship opportunities that may not be widely known. For example, many times there are small scholarship funds that may only be able to benefit one child in a particular field of study at a particular school. But if your child happens to fit the qualification criteria, it might provide funding from a source you didn’t even know existed.  Another important step is to complete a Free Application for Federal Student Aid (FAFSA) application to explore federal student aid funding options. You can learn more about the FAFSA application at https://fafsa.ed.gov/    Taking time to do careful research into all the options available may help preserve retirement funds so that they can fulfill their intended purpose, which is retirement for the parents.

Of course, in this case Ralph and Sandy are in the middle of an education funding crisis, scrambling for funds to cover costs that are due in the near term.  When one is in the middle of a crisis, one does what one must do.  For many other parents who have a little more time, planning ahead for education funding can go a long way to keeping this kind of crisis from ever happening in the first place.  For example, there are several types of education funding accounts authorized by Congress that even have some attractive tax advantages as well.

One of the best of these is the 529 plan.  529 plans have been around for quite a number of years and are probably the most popular education funding savings method in use in America today.  Interestingly, 529 plans are state specific, that is each state has its own authorized version of a 529 plan and some states offer important tax incentives to save money in those plans. The basic parameters of all 529 plans is that each will name an adult (usually the parent or grandparent) as the owner of the plan and then name a child as the beneficiary of the plan. Money deposited into the 529 plan is not tax deductible at the Federal level, but the IRS rules for 529 plans allow for all investment earnings to accumulate in a tax deferred manner.  When withdrawals are made for qualifying educational expenses, the withdrawals come out of the 529 plan tax free. This tax deferred build up and tax free withdrawal can make a 529 plan a powerful savings tool to prepare for future education expenses.

These plans are also very flexible. If the designated child doesn’t need all the funds in their account, the adult owner of the account can use the funds to meet the education funding needs of other immediate family members.  If all education funding expenses have been met and there is no further need for the education funds in the 529 plan account, the money can be withdrawn and used for any other purpose, such as supplementing retirement spending needs. The only catch is that income taxes will have to be paid on the withdrawals, since they are not being made for qualified educational expenses. 

As I mentioned earlier, some states offer 529 plans with tax incentives for taxpayers living in that state.  For example, some states offer a state income tax deduction for deposits into a state sponsored 529 plan.  Some states offer special tax incentives to employers who offer 529 matching funds for their employees.  There are even some states that allow a state income tax deduction even if the money is invested in another state’s plan.  Everyone is free to choose any state sponsored plan and there is no requirement that anyone only access the plan offered by the state in which they live.  However, most of the tax incentives that are offered are offered to taxpayers living in the same state as the plan chosen.

Financing a child’s education can be a daunting task and sometimes an expensive one.  While a gifted child may merit scholarships and grants, for most parents and students, they will have to find their own way. If you start early and plan ahead, you can avoid the pain, fear and frustration that Ralph and Sandy experienced.  Get help from a knowledgeable financial advisor to sort out the best options for you and your family situation.  You may also want to visit my website at www.erichutchinsonfinancial.com to access several blog posts, instructional videos, and media interviews on this topic.  All the resources on my website are free and available to everyone.  For a more comprehensive suite of tools and financial information, consider obtaining a copy of my book, “The Financial Briefing: Answers to Life’s Most Important Questions”.  If preparing for retirement is part of your personal financial agenda, you may want to take my free Retirement Readiness quiz which you also find on my website.   

Eric Hutchinson, CFP®

The opinions expressed in this commentary are those of the author and not necessarily the views of United Capital Financial Advisers, LLC.  Certain statements contained within are forward-looking statements, including, but not limited to, predictions or indications of future events, trends, plans or objectives.  Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties.  This material is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment.  United Capital does not warrant the accuracy or completeness of the information. The commentary is intended for information purposes only, is not a recommendation to buy or sell any securities, and should not be considered investment advice.  Past performance doesn’t guarantee future results.

Section 529 plans are not guaranteed by any state or federal agency. Before investing in a 529 plan, please read the plan disclosure document and other relevant documents carefully. Also, consider the investment objectives, risks, charges, and expenses carefully. As with other investments, there are generally fees and expenses associated with a 529 plan.

United Capital does not provide tax advice. The tax implications should be discussed with your legal and/or tax advisors because they can vary significantly from state to state. Also note that most states offer their own 529 plans, which may provide advantages and benefits exclusively for their residents and taxpayers. Investments in college savings plans that invest in mutual funds are not guaranteed by state governments and are not federally insured. Please remember there’s always the potential of losing money when you invest in securities.