The Lowdown on Paying for Higher Ed
Are you prioritizing your child’s college fund over your retirement savings? Big mistake.
Mya Payton, 58, of Southeastern Pennsylvania, is divorced with four children, the last of whom is in college now. "Over the course of the time my kids were in college — 2014 to now — their dad has been willing to pay for 50% of their college tuition and some related expenses, leaving each kid and me to fund/find the rest."
Payton has paid her share through a combination of liquidating most of her non-retirement savings, taking out equity in her home, and forgoing all but the bare minimum to her self-employed pension plan (and in at least one year, not making any contribution at all).
To help her last child, Payton said she is considering liquidating some retirement savings next year, when she turns 59½ and thus will no longer have to pay a 10% early-withdrawal penalty included in tax-deferred retirement-savings programs. Her goal, she said, is to "hopefully avoid [student] loans."
Is that a great idea or one of the worst financial mistakes a parent can make?
Eric Nero, a Certified Financial Planner and president of First-Step Wealth, a comprehensive wealth-planning service in Saratoga Springs, New York, says many parents think that tapping or stopping their retirement savings is a viable way to help their children pay for college and graduate school student loan-free.
A Big Mistake, Made by Many
In fact, he says, the resulting loss of compound interest, tax breaks, time, and financial aid eligibility make this one of the biggest financial mistakes parents make.
A 2022 Retirement Confidence Survey by the Employee Benefit Research Institute found that more than 4 in 10 working parents say they are reducing what they save for retirement because they are also saving for a child's college education.
And a recent report from Morningstar, the financial research firm, says parents who put money in a college fund rather than a retirement account miss out on many thousands of dollars in investment gains, compound asset growth and income tax breaks that can make for a comfortable retirement.
"The vast majority of the time, it is a very bad idea to take savings away from a retirement plan to contribute somewhere else," says Doug Carey, CFA, owner of WealthTrace, a retirement and financial planning software company in Boulder, Colorado.
"The vast majority of the time, it is a very bad idea to take savings away from a retirement plan"
That is because contributions to retirement plans such as a 401(k) or traditional IRA are exempt from both federal and state income taxes. Instead, you pay taxes when you take money out of these accounts and presumably you are in a much lower tax bracket.
What's more, Carey explains that a 529 plan is only pre-tax for state income taxes. If a couple's marginal federal income tax rate is 32% and they contribute $20,000 to a 529 plan rather than a 401(k), they miss out on $6,400 in federal income-tax savings.
"Not only that," he says, "but the lost $6,400 does not get to compound over time due to not being invested."
Reasons to Put Retirement First
Following are other reasons financial advisors discourage parents from contributing to their kids' college funds at the expense of their own retirement:
You can't recoup lost time or taxes. As you age, you won't necessarily be able to work at the same high-paying job you did during your peak earning years so putting off saving for retirement until your children graduate could bite you financially.
Layoffs, burnout and illnesses have a way of cropping up in the years before retirement. And even adding a part-time job will not be enough to make up for those lost contributions.
There are no loans for retirement. While students can take out loans to finance their education, parents can't borrow to finance their retirement. Students usually have many years to pay back student loans; such debts might even be forgiven, depending on your child's career, government policy or military programs. In August 2022, President Biden forgave borrowers $10,000 in federal student loans by way of executive order.
Compound interest is powerful. Darren L.Colananni, a CFP and wealth management advisor with Centurion Wealth in McLean, Virginia, likes to call compound interest the ninth wonder of the world. Let's say you have $100,000 in a retirement account, and it earns 7% per year for 20 years. Assuming no other contributions, your nest egg would grow to $387,000. Now take the same $100,000 with only 10 years until retirement and let's assume a higher rate of return, like 10%.
Time Is Money, Really
"Even though you get a better rate of return, your nest egg would only be $257,000," says Colananni. "That's $130,000, a huge difference. Having time in your retirement account is more important than less time with a higher rate of return."
You may miss out on free money. The decision to stop contributing to a 401(k) plan can hurt more if doing so makes you miss out on a company match. Many employers match employee 401(k) contributions up to a certain percentage of their salary. That is, essentially, free money and it is important to take it.
"It can be an even worse decision to withdraw money from a 401(k) plan to pay for a student's college expenses if the 401(k) plan owner is not yet 59½," says Carey. You would have to pay a 10% penalty on the withdrawal as well as federal and state income taxes. Even if you're over 59½, you would still owe income taxes on the withdrawal, and the money would no longer grow tax-deferred inside the plan.
Things to Consider
Beware of burdening the kids. Carey thinks it's ironic that parents would use their retirement savings to pay for college for their children when doing so makes it more likely they eventually will become a burden on their kids by running out of money in retirement. You can avoid this fate by contributing to your retirement plan and letting the money compound over time. Experts think to do anything differently is to fail your kids. When you shortchange your retirement savings, your set your adult kids up for one day having to support you — something most of us want to avoid.
"Talk about a double whammy — less money for retirement and less financial aid, which means you may need more money to pay for college."
You endanger financial aid. Finally, withdrawing money from your retirement savings to pay for college can make it harder to qualify for needs-based grants and scholarships. Colleges do not count retirement savings when calculating financial aid for students, but treat withdrawals from retirement savings as income.
"Talk about a double whammy — less money for retirement and less financial aid, which means you may need more money to pay for college," says Taren Coleman, a Chartered Retirement Planning Counselor at College Money Smart, a service that matches college-bound students with institutions they can afford.
The same applies if you cash out home equity from your home– those dollars count as income in the need-based financial aid calculation.
It might sound noble to help your children pay for college — but not at the expense of your retirement savings. Instead, look for schools that will give them the best value for their money, support their journey and help them apply for all the grants, scholarships and other aid available to them, without making a significant financial mistake for your retirement.