Published May 16, 2012
Visions of your child donning cap and gown at a college commencement ceremony may inspire you to start a savings account right away. But your child's college fund isn't the most pressing financial priority, say the experts. While Junior has financial aid opportunities ahead, families won't have the same fallback plan for other types of expenses.
Saving for college doesn't necessarily have to be at the bottom of your list, but you should put your money in these three places before starting a dedicated account.
Ideally, a 529 college savings account grows 6% to 8% per year. Even if you're lucky enough to get such good returns, saving for college before paying off high-interest credit card debt doesn't make sense, says Bill Olsen, managing partner with Asset Strategies Group, a financial advisory firm headquartered in San Antonio.
"The habit needs to be fixed that created the debt in the first place," he says. "We continuously run into people that will work for three years and pay down a credit card debt -- and then turn right back around and run it right back up."
Paying off credit card debt can also qualify families for more federal financial aid and better interest rates on private student loans. The government doles out need-based grants, work-study jobs and some loans based on a family's income and assets, but it doesn't take outstanding debts into consideration. Federal Stafford student loans with favorable rates are available to nearly all two-year, four-year and graduate students enrolled at least half time, regardless of their credit scores. However, private student loans and federal Parent PLUS loans require families to pass a credit check.
Olsen adds that other high-interest debts such as pricey auto or personal loans should also take precedence over college savings.
"Any interest rate that is above 5% and is not tax-deductible should be attacked right away," he says.
Once funds are in a college savings vehicle, there are usually incentives to keep them there. Account holders of 529 plans and Coverdell Education Savings Accounts pay a 10% penalty on interest earned by the accounts and back federal income taxes on fund growth if the funds withdrawn are not used for a qualified expense.
To ensure families can cover unexpected costs, George Long, a financial adviser with Sapient Financial Group in San Antonio, recommends stockpiling an emergency fund of at least three months' worth of expenses before saving for college.
"If you feel that your industry is under scrutiny or that your job is not guaranteed, it may be wise to have six (months' worth), maybe even a year of your expenses put aside," he says.
Long adds that preparing for a rainy day also means spending money now on items such as health, life and disability insurance to safeguard against a catastrophe.
"If you start putting $100 a month into a college fund and do that for five years, you're going to have about $7,000, depending on the return," he says. "However, if we took $50 a month and we bought you term life insurance and there was an unforeseen death, what's going to be the better use to your family: a $7,000 college fund or maybe a $1 million death benefit?"
"You can borrow if you need to for college education. You cannot borrow to fund your retirement," says Jeffrey D'Italia, senior financial professional with Firstrust Financial Resources wealth management firm in Philadelphia.
While students have scholarships, grants, loans and alternative aid programs to help foot the cost of four years of college, parents have few outside resources to help fund 10, 15 or 20 years or more of retirement.
Choosing retirement over college savings can actually help pay for school, too. Retirement accounts, including 401(k) plans, IRAs, pension plans and annuities, are among the few savings vehicles that aren't counted in the federal aid methodology that determines a family's expected annual contribution to college expenses. Low, middle and upper-middle income families who may qualify for need-based aid can actually increase their likelihood of landing help from Uncle Sam and their college of choice by maxing out their retirement accounts before saving for college.
There is one way to save for retirement and college without losing financial aid, says Gary Gilgen, director of financial planning for Rehmann Financial wealth advisory firm, which is headquartered in Michigan.
"(Parents can) put money in a Roth (IRA) and still use it as cash reserves and retirement all in one bucket," he says. "They could then pull that out and use it when the time is right for funding education."
Traditional and Roth IRAs provide federal income tax-free growth and allow parents to withdraw without penalty if the proceeds pay for college. IRA funds won't be counted in the federal aid methodology as long as they're in an IRA. Once the family starts taking withdrawals, however, that money does count as income. For every dollar withdrawn from an IRA, the student can lose up to 50 cents in federal financial aid.
There may also be tax implications. Parents who withdraw funds from traditional IRAs will have to pay federal income taxes on the withdrawal, as well as state income taxes where applicable. Withdrawals from Roth IRAs that were set up five years before or longer are tax-free. But if withdrawals are made within five years of opening the account, taxes are due only on interest the account has earned, not the original contributions since those are made with after-tax money.
To sidestep losing financial aid, parents can use funds stored in a different college savings vehicle such as a 529 plan or Coverdell account to pay for the first three years of school, then tap into IRA funds to help pay for the last year after their student has applied for federal financial aid.
Just make sure you're on track for retirement before using your IRA funds for college.