Like the chicken or the egg, many parents want to know what to save for first: their kid’s college or their own retirement. This is actually one of the 20 tough financial questions posed in the “Do This or That?” list in Kiplinger’s Personal Finance magazine.
For most people, the answer is to first save for retirement. Savings is the primary way to fund your retirement, but there are a variety of ways to fund your kid’s college. The Wall Street Journal reported that for the 2012-13 school year, parents on average paid 27% of college tuition from income and savings. The rest came from grants and scholarships (30%), student loans (18%), student income and savings (11%), parent borrowing (9%), and relatives and friends (5%).
You can make saving for college a priority if you are lucky enough to have extra money coming your way for retirement. Inheritance, beneficiary of a trust, large guaranteed pension benefit – all these are examples of retirement windfalls that may enable you to first save for college.
If you are within 20 years of retiring and you have not met your retirement funding goals, you need to plow all the money you can into retirement accounts. If you pass up on socking money away in your 401(k), you are leaving money on the table. You are missing the employer match for free money. Plus, retirees don’t get to fund their living expenses with scholarships, grants or federally guaranteed loans. Our federal financial-aid system disregards tax-sheltered retirement plan money in calculating your kid’s odds for financial aid.
The Best Way to Do Both
Start with studying the rules on college financial aid. We all complain about these rules being excessively burdensome, grueling, highly technical and downright yucky. However, when you understand the way financial aid qualification is determined, you can create a windfall to pay your kid’s college years.
There are two types of college financial aid: based on need and based on merit. The former is based on your family financial situation. The latter is most often based on your kid’s grades and less often based on your kid’s remarkable talent like athletics or music. We are going to focus on need, since I can’t tell you how to groom your child for a basketball scholarship.
We first turn to a mathematics equation. The Cost of Attendance at a school MINUS your EFC or Expected Family Contribution EQUALS your Need. This equation rewards parents’ savings at varying levels, more in some types of accounts and less in others. The greater the college costs and the smaller the EFC, the better your kid has a chance of getting financial aid. This is true whether you are talking about the FAFSA form or the CSS Profile aid application. FAFSA is the Free Application for Federal Student Aid, the most common form to complete. It helps calculate whether your kid qualifies for federal grants and subsidized student loans. About 300 colleges across the country use the College Board’s College Scholarship Service (CSS) Profile form for determining discounts on tuition.
Your qualified retirement and IRS accounts are the key accounts in the equation. These accounts are ignored when you add up your assets and income available for paying those college bills. That leaves your other assets to be included in the mathematics of qualifying for financial aid. Your savings, checking, CDs, money market, mutual funds, stocks, bonds, commodities, ETFs and investment real estate are all counted in the EFC number. However, you need to know which colleges use which formulas. Educate yourself so you know how your finances will play out in the respective mathematical formulas.
Nifty Things You Can Do
Save in qualified retirement plans like 401(k)s and 403(b)s. Grab the employer matching contributions. Those don’t count against you in the financial aid equation. If you are a business owner and employer, the company contributions to your account are not added back into your income in the equation.
Fund a Roth IRA because IRAs do not count against you in financial aid calculations. Your Roth IRA contributions do not get added back into your income because they were not a deduction on your tax return. In the worst case, you can eventually pull some money out of your Roth for college costs, but before you do, check with a CPA on the current rules governing taxes and penalties.
Get life insurance. Cash values on life insurance policies do not count in the EFC. You can also use that cash for college costs. If the insured person dies before or during your kid’s college years, you can use the life insurance proceeds to pay for college.
Maybe own non-qualified annuities. These don’t count on the FAFSA form, but they do count on the CSS Profile form. Thus, there is not a consistent answer on whether to own annuities when it comes to qualifying for financial aid purposes.
Invest in a 529 plan. There are two different types of 529 plans the 529 College Prepaid Plan and the 529 College Savings Plan. The most common is the College Savings Plan. This is a tax-advantaged account for building up assets to use at any accredited college or vocational school in the country. The 529 Prepaid Plan allows you to buy tuition credits in your home state’s university system at today’s prices. As with all investments, do your research before you buy. You get tax-free growth, and the money isn’t taxed when you take it out for college expenses. When parents own the account, they are included in the mathematical equation.
Try to pay off debts before your kid gets to college. When Junior is in college, your cash out-go will rise significantly.
With the cost of college increasingly high, you might be tempted to dip into your retirement to fund Junior’s college costs. Beware — doing this can be very expensive. You risk having to ask your kids for money when you are elderly. If you want a comfortable lifestyle in your retirement years, don’t break the bank paying for the best college.