Pay For A College Education With Retirement Funds

By Alan Feigenbaum AAA

You can usually borrow to finance a college education - regardless of credit rating or income level - but the same is rarely true for funding your retirement. If you\'re the parent of a future or current college student, or are faced with financing your own college education, it\'s usually recommended that you put your retirement savings ahead of paying for college expenses. For many people, this is still a hard choice to make. Read on to learn some of the ways you can determine how to balance college and retirement funding.

College Financial Need
College costs are increasing so much faster than inflation that financial aid formulas are likely to determine that your family has financial need, which is defined as the difference between the (full) cost of attendance and your expected family contribution (EFC). Unfortunately, at least half of the typical college financial-aid packages available for meeting that need are made up of loans, and many families are forced to borrow even more because they don\'t have the resources to fully cover the formula-calculated EFC. (Visit the Free Application for Federal Student Aid (FAFSA) website for details.)

Still, some financial aid is better than none, and unsecured loans at reasonable rates with minimal or no qualifications are better than the terms usually available for non-collateralized personal loans, such as those used to purchase a car. As such, it is best to qualify for as much aid as possible by having the lowest possible EFC, while building up sufficient assets to handle any loan obligations. Amazingly, many families who can get maximum eligible financial aid miss out because they don\'t understand the rules that apply to their specific financial situations.

The Case for Retirement-RevvingCollege Financing
So let\'s make a case for building up retirement assets while preparing to borrow for college. We\'ll begin by reviewing the rules:

  • Expected Family Contribution: The federal formula that determines how much your family should be able to contribute is based on a percentage of both parents\' (30%) and child\'s (50%) previous year\'s incomes, and a percentage of parents\' (up to 5.6%) and child\'s (35%) assets assumed available to spend down - all recalculated yearly. 529 plans became much more attractive to families expecting financial aid when the Higher Education Act was revised to treat them as parents\' assets regardless of how they\'re titled. However, assets in retirement accounts go one better because they\'re not counted at all, which means that amounts in 401(k), IRA, 403(b), federal thrift plans, or other similar accounts are considered unavailable; the same is true for home equity. (To read more, see Choosing The Right Type Of 529 Plan and Clearing Up Tax Confusion For College Savings Accounts.)

    Consequently, upper-middle-class families whose net worth is largely tied up in home equity and retirement accounts may qualify for some financial aid, even if they\'ve also accumulated significant amounts in 529 plans. More affluent families should be aware that many elite private colleges do count excessive home equity and retirement funds in their own formulas for non-federal financial aid.

  • Pre-Retirement Account Access: Amounts in Roth IRAs can be withdrawn tax- and penalty-free if the distributions are qualified. For nonqualified distributions, amounts are penalty-free if used to pay for qualified educational expenses and only amounts attributable to earnings are subject to income tax. For Traditional IRAs, amounts can be withdrawn penalty-free if the distribution is used to pay for qualified educational expenses; however, any taxable portion of the withdrawal will be treated as ordinary income for the year the withdrawal occurs. While amounts in qualified plans and 403(b) arrangements do not qualify for the early distribution penalty exemption for college related expenses, they may be available to pay such expenses if the plan so provides. (To learn more, read Tax Treatment Of Roth IRA Distributions and Taking Penalty-Free Withdrawals From Your IRA.)
  • Tax-Favored Education Savings Alternatives: 529 plans offer tax-deferred growth and tax-free distribution for qualified educational expenses. Some states even allow tax deductions for residents\' contributions to their 529 plans , with no income ceiling for contribution eligibility. Parents who make contributions within the annual gift-tax limit ($13,000 per parent in 2009) upon a child\'s birth can reasonably expect to fully cover even the most expensive college\'s costs, assuming moderate returns on investments. But the tradeoff for tax-deferred growth and tax-free distribution is that funds must be used for college expenses for the beneficiary. Thus, unlike Roth IRAs, for which distributions for retirement can be tax-free, 529 plan assets can\'t be used for retirement on a tax-free basis.
  • College Loans: Repayment on student loans can be fully deferred until six months after the student is no longer attending college for at least half-time, and some payment plans allow for graduated or stretched-out repayments. Furthermore, although repayment on federal parent (PLUS) loans usually must start immediately after the loan has been granted, graduated and extended repayment plans are also available for these amounts. Finally, interest of up to $2,500 per year on a college loan is deductible subject to certain modified adjusted gross income limits.

Opening Your Financial Statement
The evidence supporting saving for retirement first is compelling for most families, but don\'t rush to judgment until you open your financial statement. Here\'s what you should look for to determine whether an overlapping retirement-college investing approach fits your circumstances:

1. Can you manage the burden of a large loan?
Lower-income families usually aren\'t able to save (much) for either retirement or college, but do qualify for aid that covers most college expenses - including federal Pell Grants, (lowest-interest) Perkins Student Loans, (still-below-market-interest) subsidized Stafford student loans and market-rate unsubsidized Stafford loans. Furthermore, federal PLUS loans at current competitive market rates enable parents to borrow up to the balance of what isn\'t covered by the rest of the financial aid package, provided they pass minimal credit tests (not based on credit score). They can, therefore, at least initially finance even the most expensive colleges. However, they\'re unlikely to be able to keep up with the huge loan burden, and are better off targeting state public colleges unless their children can snag enough scholarships or merit-based aid to avoid higher loan amounts than state colleges would require.

Thus, rather than saving for college, they should use any savings they can harvest to make 401(k) contributions up to what their employers match, putting any excess in a non-retirement emergency fund to ensure that they can cover unexpected bills and keep their credit records clean. Furthermore, their kids should put any employment earnings that they don\'t spend into Roth IRAs to avoid jeopardizing full aid eligibility. Due to the Hope Credit, which is large enough to cover a good portion of community college costs, students from very low-income families who go that route could accumulate enough in Roth IRAs to make an affordable transfer to a four-year state school feasible. Here, they would receive less (but still significant) financial aid for their junior and senior years from the Lifetime Learning Credit.

2. Are you already carrying a heavy debt load?
Middle-income families are more likely to be headed up by college-educated parents, so they\'re more likely to include private schools in their application pools. These families generally don\'t qualify for Pell Grants or the full Perkins loans, but usually qualify for fully subsidized Stafford loans. Although they generally have less financial need, they may also lead high-consumption lifestyles that leave them feeling that their expected family contributions are too large. Furthermore, those that opt for private colleges tend to take large PLUS loans, which they may struggle to repay. In addition, their kids often take maximum combined subsidized and unsubsidized Stafford loans, and higher-rate non-Federal private loans, often resulting in eventual repayment delinquency and default.

By recognizing these traps in advance, these families can benefit from careful budgeting. This will enable them to save more, receive full matching 401(k) contributions where available, and make significant IRA contributions, preferably to Roth IRAs in instances where traditional IRAs are not suitable. As noted earlier, those Roth IRA balances will not reduce their aid eligibility, yet the principal amounts will be available for withdrawal without taxes or penalties as supplements for burdensome loan payments that might otherwise be defaulted on. (For more insight, read The Beauty Of Budgeting and Six Months To A Better Budget.)

Meanwhile, the untouched earnings on their Roth IRA investments will continue to grow and, combined with 401(k) and other retirement savings, will give them a good start toward a retirement nest egg. Even though 529 plans allow individuals to contribute more than the amounts permitted in 401(k) plans and Roth IRAs, they make little sense for these families because they will likely not need 529 saving amounts to pay for college. Therefore, if they can find the financial resources to save enough to fund more than is required to receive 401(k) matching contributions and fund their Roth IRAs, choosing to fund a 529 plan instead is not worth the risk that their kids decide against going to college, which could cause the 529 earnings to be taxable.

3. Do you plan to send your children to a private college?
Upper-middle-income families often send their kids to private colleges, so it\'s particularly important that they take full advantage of retirement savings opportunities, instead of adding to college savings accounts or regular savings. This will increase the possibility that they will qualify for a limited financial aid package of small grants and partially subsidized Stafford loans. Although the dual retirement-college virtues of Roth IRAs also apply to these families - assuming they satisfy the Roth IRA contribution eligibility requirements - it\'s often best for them to make maximum 401(k) contributions (even beyond what gets matched). This will allow them to get current salary reduction tax savings when their tax brackets are likely relatively higher than they would be during their retirement years when withdrawals usually occur. When the repayment period for PLUS loans begins, they should consider reducing retirement contributions if necessary and diverting these amounts to PLUS loan repayments. Additionally, they will benefit from the student loan interest tax deduction available for PLUS loans.

The thriftiest and more affluent of these families might have combined retirement assets and home equity large enough to be partially counted in private college aid formulas, so they\'re more likely to be ineligible for any financial aid, and may not have lower tax brackets during their retirement years. Accordingly, these individuals might be better served if they choose to fund 529 plans instead of making contributions to 401(k) plans that will not receive matching contributions.

4. Does your high income exclude you from qualifying for financial aid?
Lower-tier high-income families generally have incomes that are too high to qualify for any financial aid, yet not large enough to comfortably pay the full private college tab. For these families, it\'s crucial that they avoid conspicuous consumption and concentrate on saving enough to fully fund 401(k) accounts and Traditional IRAs, even if contributions are non-deductible, along with any other tax-deferred retirement savings vehicles for which they are eligible. In addition, they should fund 529 plans with enough to finance about two years\' worth of college costs by the time their children enroll. With the combination of the proceeds from a home-equity loan or line of credit (which is the preferred option for those whose high incomes may cause them to be ineligible for student-loan interest deductions) and the 529 savings, these families should be able to comfortably cover any lump-sum semester bills and cover the monthly loan payments out of current income. (For more on conspicuous consumption, read Stop Keeping Up With The Joneses - They\'re Broke.)

5. Does your employer provide you with a very high income and sophisticated retirement plan?
Truly high-income families often have sophisticated retirement arrangements as part of the fringe benefits they receive from their employers. As such, this should permit them to fully fund additional retirement accounts and education savings accounts - such 529 plans - to the point of accumulating enough to cover all college expenses.

Closing Arguments
Balancing saving for both college and retirement is a difficult task, but remember that the two goals need not be mutually exclusive. Although retirement may be a goal that is many years beyond your children\'s\' college educations, retirement vehicles may actually offer a good alternative to traditional education savings vehicles for some families.

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