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Guru Q&A Deluxe: Should I Save for Retirement or College?

Our gurus are having a healthy debate on whether you’re better off putting your money in an IRA for retirement or in a 529 for your kids’ college. Check it out and then add your own two cents here.

FiLife User Question: I have no savings and I am 35. I have 2 kids. I can save $500 a month - should I save for retirement or for my kids college?
-nrek123

FiLife Guru Response from Dave Hanson: Our planning guru Michael will give you a thoughtful answer when he gets a moment. In the meantime, I’ll give you my take: save for retirement before college. Here are a few reasons why:

-You Can’t Finance Retirement. College can be funded via loans, scholarships, grants, et cetera. Your retirement cannot be.

-Financial Aid. Retirement account savings generally will not count against financial aid formulas. At least a portion of your college savings will.

-Saver’s Tax Credit. If your adjusted gross income is below $53K (joint, or half that if single), then you qualify for a CREDIT (not deduction) that can be worth close to $1,500 on just $4,000 in retirement savings. An excellent piece on this credit is available here.

-Employer Matching. Many 401(k) plans will match a portion of the money you set aside for retirement. That’s “free money,” and should’t be passed up. College savings doesn’t give you that benefit.

-Better Investment Options. IRAs offer unmatched flexibility and many options for extremely low fees. College savings accounts like Coverdell IRAs and 529 plans have improved, but still don’t match that flexibility.

-More Flexible Withdrawals. Many retirement accounts provide for the penalty-free withdrawal of funds for any number of reasons–including paying for college. College savings accounts generally do not.

-Creditor Protection. IRAs and 401(k)s are generally fully protected if you should need to declare bankruptcy. College savings accounts offer some protection, but it is more limited.

Bottom line: With $500 a month to save, retirement should come first. Ideally, you will be able to increase your savings over time. Sometime after that point. it will start making sense to fund college savings accounts as well.

FiLife Guru Response from Mark Kantrowitz: Your goal, at a fundamental level, is to maximize your money. Money is fungible, meaning that it doesn’t really matter if it is in a 529 plan or a retirement plan. If you have more money in your retirement plan, then you’ll feel more comfortable spending current income on college costs. Likewise, if you have more money in your 529 college savings plans there will be less pressure on your income during and after the college years, so you’ll be able to save more for retirement.

So you should take steps that maximize your total return on investment. As Dave says, if your employer provides a matching contribution, maximize the match. If your state 529 college savings plan provides for a state income tax deduction on contributions to the state 529 college savings plan, take advantage of that too.

I discuss this in more depth in FinAid’s Saving for College section.

I have a few comments on Dave’s response:

- Don’t count on taking a distribution from your retirement plan to pay for college expenses. Although you can avoid the 10% tax penalty, you will still have to pay regular income tax on the distribution. In addition, the distribution will be included in your adjusted gross income and so affect your aid eligibility next year. It just isn’t financially worthwhile.

- There are ways to finance a retirement, such as reverse mortgages. While it is true that there are a variety of ways to pay for college, saving for college increases your options and maximizes choice.

- In a worst case scenario, money in a 529 college savings plan will reduce aid eligibility by 5.64%. However, less than 7% of dependent students have any contribution from parent assets. This is because money in retirement plans, life insurance plans, the principal place of residence and small businesses owned and controlled by the family are not counted, and the first $40,000 to $50,000 of other assets for the typical family are excluded. After that the parent assets are assessed using a bracketed system with a top bracket of 5.64%.

- Most 529 college savings plans have deliberately few investment options. This is partly because 529 college savings plans are long-term investments where broad-based market indexes are sufficient. Most mutual funds do not beat the return on investment from the S&P 500, so why even bother? It is better to invest in a broad-based market index that is managed to minimize costs than to bet on a particular fund manager beating the market as a whole.

So I’d argue that you should first look at your investment options and spread the savings across the options in a way that maximizes your total return on investment. For example, if your employer does not offer a match but you live in one of the 32 states that provide a state income tax deduction for contributions to the state’s 529 plan, you should invest in the 529 plan first.

FiLife Guru Response from Dave Hanson: Thanks for the useful exchange Mark! Your points are well taken.

In particular, I appreciate your pointing out the state income tax deduction for state residents investing in certain 529 plans. I’m based in a non-income tax state, so this isn’t an issue for the folks I advise here. But of course you’re correct that for those who are paying state income tax, this factor is well worth looking into.

My only caution here is that I think you overstate the point when you conclude, “if your employer does not offer a match but you live in one of the 32 states that provide a state income tax deduction for contributions to the state’s 529 plan, you should invest in the 529 plan first.” There are exceptions. The most obvious would be when a saver with a modest state savings tax liability might qualify for a sizable Saver’s Tax Credit. That credit is eligible only for those who save in retirement accounts, not college savings accounts. For many savers, the benefit from the credit would dwarf the benefit from state income tax savings.

I’ll follow up on a few of the other points you made in this reply.

-You are correct that taking distributions to pay for college from tax-deferred retirement accounts are subject to increasing one’s AGI, and hence their financial aid eligibility. This is why I advise taking distributions from this purpose for Roth accounts instead, on which the tax has already been paid. Of course, if one doesn’t need to tap the Roth or Traditional retirement accounts to pay for school, so much the better! But Roth withdrawals are more favorable for financial aid purposes than 529, Coverdell/Education IRA, or traditional IRA or 401(k) accounts.

-I think it’s a bit misleading to suggest that reverse mortgages allow for “financing a retirement.” Most obviously, they are financing one’s home, not one’s retirement. Thus they are only available to homeowners with equity, and they can be used for any purpose (including kid’s college), not just retirement. Moreover, they often bring with them high fees and a set of other problems (which are worth exploring on another FiLife thread).

-I don’t think we disagree on the advisability of index investing for long-term savings like retirement or college. But even the best 529 plans add a layer of fees on top of what the index funds would charge if they were held in a no-fee IRA. This is why when all else equal, a no-fee IRA or Roth IRA can provide higher returns than a 529. (I will say that 529 plans have improved their fees significantly in recent years. I especially like the Illinois “brightstart” 529 plan for those who don’t benefit from a tax deduction by using their own state’s plan).

Bottom line: We agree that saving for retirement AND for college is desirable. We also agree that having different savings vehicles from which to chose (IRAs, 401(k)s, 529s, Education IRAs, et cetera) is desirable. But nrek123’s asked where one with NO savings and $500 a month should start. In that scenario, I stand by my suggestion to begin with retirement savings for the reasons I’ve mentioned.

Thanks again for engaging my answer here, Mark. I look forward to what Mike might add, as well as any follow-ups that you or nrek123 have.

FiLife Guru Response from Michael Kitces: Wow, I feel like I’ve already missed the train on a great thread here!

I think Dave’s initial post here really hit the nail on the head for the primary issues. Your options for getting access to money to fund college are more flexible and available than what you can do if you don’t have enough money for retirement. Some financial planners draw an analogy to the warning you hear during the safety demonstration on an airplane - you need to put on your own air mask before you help others; or in this case, you need to secure your own financial future before you try to help others. Otherwise you run the risk that by spending more than you can afford on your children’s college education, you may end out depending on your children to support you in retirement. In some families that’s a “normal” family tradition, but more and more I see parents that wish to avoid this, if only for fear that they may become a burden on their children.

In addition, many families are finding that they actually PREFER to have children fund at least some portion of their own college education, either via their own savings or via their own loans. Why? Simply put, because in many cases children who have a direct financial stake in their college education take the investment more seriously. Of course, this varies by the child and the family, but in many cases parents are starting to prefer to have children help with their own college funding - which of course, also leaves you more flexibility to save for your own retirement as well.

I won’t reiterate the rest of Dave’s great points, but let me just add quickly that ultimately this is still a very personal decision. Some families have a strong preference to fully fund a child’s college education, even if it means sacrificing their own retirement future. Ultimately, that’s a trade-off decision that we all make for ourselves. But from a general planning perspective, securing your own retirement financial future will leave you in a capable position to help your children at many points throughout their lives (and your children just might take college more seriously if they have a financial stake in it). Sacrificing your retirement future to fund a child’s college education increases the risk that you may become depending on the children in the future. But in the end, you still have to make the decision for yourself based on your own family goals and beliefs!

I hope that helps a little!

-FiLife Gurus Dave Hanson, Mark Kantrowitz and Michael Kitces

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