It’s a difficult choice: should parents focus on saving for retirement or a college education for their children? For many families, meeting one of these goals is a challenge, and juggling both can seem impossible. How, then, can you help your clients make the right decision or balance their priorities? The right choice, for many clients, will be clear. For the reasons I discuss below, most parents should make saving for retirement their priority. Let’s explore the financial planning issues at stake.
Lots of Funding Vs. Not So Much
Funding for a college education is widely available from a range of sources, including student loans, grants, and scholarships. The funding options for a retiree are much more limited—social security and personal savings are the primary sources of income for most people. How can parents accumulate enough personal savings to fund their retirement? Given the rising costs of living, achieving that requires discipline throughout an adult’s professional life.
Parents who fail to build an appropriate nest egg might not be able to enjoy the retirement lifestyle they envision. Although they may wish to fund a child’s education fully, they would be wise to avoid a scenario in which they’re left with insufficient savings to cover retirement costs.
All Costs Go Up, But . . .
Educational expenses are much more variable than retirement costs. Although inflation drives both types of expenses up, students can take advantage of large cost differences between public versus private and in-state versus out-of-state institutions. In addition, the availability of online educational options allows students to control costs. Even if parents want their children to be able to attend any institution, a budget can guide a different decision. Parents won’t have that flexibility when they’re retired—not without making sacrifices to the lifestyle they desire.
529 Plans: Upsides and Downsides
Before deciding whether to fund a 529 college savings plan, parents should pay attention to this vehicle’s defining features.
Upsides:
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Contributions grow tax free, and withdrawals for qualified expenses are untaxed.
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Many states offer state income tax deductions for contributions.
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Contributions can be front-loaded with up to five years’ worth of the annual exclusion gift of $15,000 (up to a total of $75,000). This incentive is unique to 529 plans.
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Assets held in 529 plans aren’t included in an individual’s taxable estate at death. (Parents should note that the high limit for the estate tax exemption—$11.58 million for individuals and $23.16 million for married couples in 2020—means this feature won’t assist many people.)
Downsides:
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If 529 distributions are taken for nonqualified expenses, they could be subject to tax on the account’s gains, as well as a 10 percent penalty.
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529 accounts are included as a parental asset for determining the amount of aid available under the Free Application for Federal Student Aid (FAFSA).
A Relatively Inaccessible Nest Egg
The features of IRAs and 401(k) accounts should factor into decisions regarding saving for retirement or a college education. Retirement accounts come with tax-deferral advantages on contributions, and funds left untouched can grow over time. The potential penalties and taxes on early withdrawals discourage taking money out, making IRAs and 401(k)s an easy way to commit to saving for retirement. In addition, parents typically pay a lower tax rate on postretirement withdrawals because of a lack of employment income. With respect to FAFSA, parents should note that retirement accounts do not affect a student’s aid eligibility.
As for preretirement withdrawals from an IRA, an exception applies for educational expenses. If, before age 59½, account owners take money out to pay for qualified educational expenses for themselves or their spouse, children, or grandchildren, the 10 percent penalty does not apply. (Distributions are subject to ordinary income tax.) This exception doesn’t apply to other qualified retirement plans, such as 401(k) accounts.
Parents whose employer offers a matching contribution to a qualified retirement plan would forgo a substantial amount of extra income by not participating. So, if clients are funding an education rather than putting the maximum into retirement savings, perhaps their decision should be reassessed.
A New Law Shakes Things Up
The SECURE Act of 2019 shook up many aspects of financial planning for retirement. Its most notable provisions include:
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Delay in the age for RMDs from 70½ to 72
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Elimination of the lifetime “stretch” IRA option, requiring nonspouse beneficiaries of IRAs to deplete the inherited balance within 10 years of the decedent’s death (with exceptions)
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Expansion of permitted expenses for 529 plans to include apprenticeships, as well as up to $10,000 of qualified student loan repayments for the beneficiary and $10,000 for each of the beneficiary’s siblings (an aggregate lifetime limit, not an annual limit)
Given these new rules, retirement accounts are now a less attractive asset to leave to heirs. For grandparents, a more tax-efficient estate plan might be funding 529 plans for their grandchildren rather than leaving a tax-deferred retirement account to their children.
An IRS Private Letter Ruling (PLR)
In 2018, the IRS made public a PLR that caught the attention of employers seeking a way to help employees build retirement savings while paying off student debt. This ruling, PLR 201833012, basically approved an employer’s proposal to offer matching 401(k) contributions based on verification of employees’ student loan payments. A PLR applies only to the requesting taxpayer, but this one could open the way for similar programs.
The Path to Balance
As we’ve seen, making decisions about saving for retirement or a college education involves a difficult and delicate balancing act. By educating your clients about the realities of funding sources and the benefits of available saving vehicles, you can help them plan appropriately. So, take the initiative. Discuss these issues with your clients. With the right guidance, it’s possible for parents to provide for their children’s education without compromising a comfortable retirement lifestyle.
