Many families are thinking twice these days about resorting to some of the tactics commonly used to pay for education. Parents are more hesitant to raid retirement accounts or remortgage their homes to cover those ever-spiraling tuition bills.
What are they doing instead? Many are proactively saving in 529 plans.
Over the past 10 years, the number of households with 529 savings accounts has almost doubled to more than 8 million. And researchers believe 529 accounts will grow even more rapidly in the coming years.*
Families are paying attention to the real cost of college
Parents believe college is critical to their children’s success. But they don’t want to sacrifice their own retirement to pay for it. In a recent survey, 67% of savers in 529 plans agreed (or strongly agreed) with the statement “You can borrow for college, but you can’t borrow for retirement.”**
That sentiment reflects recent changes in how parents are contributing to college costs. The amount parents borrowed or withdrew from retirement accounts dropped last year, according to Sallie Mae’s report “How America Pays for College 2017.”***
Squeezing money out of the budget to save for college isn’t easy, but it’s better than raiding retirement resources. Using retirement accounts and mortgage equity is an expensive way to fund education.
Here’s how these common practices can hurt your future:
- Borrowing from a 401(k) account. Taking a loan from a traditional 401(k) account might seem like a harmless way to shoulder the cost of college. But it means you’ll be paying income taxes twice on the money you take out. When you pay back your loan, you use after-tax money, not the pre-tax money you used to fund it in the first place. You’ll be taxed again when you withdraw the money in retirement. Other disadvantages: You’ll miss out on any growth while you’re paying back the loan. And if you leave your job while your loan is outstanding, you may have to pay the balance back in one lump sum.
- Cashing out an IRA. The IRS gives you a break when you use your IRA for higher-education expenses by waiving the 10% early withdrawal penalty. However, the leniency doesn’t extend to regular taxes. You’ll have to pay income tax on the amount you withdraw, which could bump up your tax bill significantly.
- Taking a second mortgage against your home. Some parents tap into home equity to fund college. But that can put retirement at risk as well. The reason? Low expenses are one of the keys to living well in retirement. If you’re still paying your mortgage when you’re over age 65, you could find it difficult to cover your living expenses.
Taking advantage of tax breaks
Proactively saving for college doesn’t just help you avoid drawing from retirement resources. It also offers another important benefit: A 529 account could help you save on taxes.
Most people think only federal tax breaks offer meaningful savings, but state tax breaks can add up too. And in many states, the tax benefits of 529 plans became more valuable starting this year because of tax reform.
In previous years, you could deduct all of your state and local taxes from your federal tax bill, which helped ease high state taxes. Under the new tax law, the combined state and local tax deduction is capped at $10,000. If your taxes are higher than that, it’s more worthwhile than ever to lower your state tax bill. 529 plans are among the few tools available to do that.
Although not every state offers a tax benefit, most do. More than 30 states offer a tax deduction or credit for 529 contributions.
And 529 plans do offer a federal tax break. Although you can’t deduct contributions from your federal taxes, you get tax-free earnings, similar to a Roth IRA.
Investing in a 529 plan isn’t a quick or easy solution to funding college. It takes time and effort to build up assets over the years.
But this approach allows you to balance 2 important goals, helping to pay for your children’s education while staying on track with your retirement plan. By planning ahead and keeping your savings separate, you’ll be less tempted to dip into retirement savings when tuition is due.
*Paul Curley, CFA, 2018. SI 529 Industry Analysis: 2018, p. 17. New York, NY: Strategic Insight.
**Paul Curley, CFA, 2018. SI 529 Industry Analysis: 2018, p. 31. New York, NY: Strategic Insight.
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