The College Fund You Don’t Know You Have
March 14, 2013I talk to many parents of students approaching college age who fret about having little or nothing saved for college. They know how important a college education is and want their children to be able to go to the school of their choice while graduating with as little debt as possible but at best, they only have a few thousand dollars set aside for college expenses, barely enough for one semester’s worth of meals. The rest of their money is tied up in emergency savings, retirement accounts, and a home with little or no equity. Yet, there is one potential bright spot…
If they have a retirement plan from a previous job, they can roll it into an IRA. (If they rolled it into their current employer’s retirement plan, they can roll it back out.) This IRA can then be used penalty-free (but not tax-free) for their children’s college expenses. However, there are some possible pitfalls to avoid:
1) Make sure you don’t need this money for retirement. As we financial planners like to say, they don’t exactly award financial aid for retirement. First, run a retirement calculation without this money. If you’re on track, you’re good to go. Otherwise, leave some of the money for retirement and/or save more to make up the difference. (The latter might be easier once the kids are on their own.) In a worst case scenario, ask yourself if you’d be willing to adjust your retirement goals to help with their education. The important thing is that any decision you make is a conscious one rather than just using the money for college expenses only to discover once it’s too late that you don’t have enough left to retire on.
2) Change the investment allocations in the IRA. This money should be invested a lot more conservatively than if it was going to be used for retirement. That’s because it all has to come out over a few years of schooling while retirement money may stay invested for 30-40 years during retirement. One option is to model the portfolio after one of the age-based portfolios in a 529 savings plan. These portfolios are designed to automatically become more conservative as the child gets closer to college but you’ll have to make those adjustments in the IRA yourself. Another option is to choose a conservative balanced fund or even just stick to a money market fund if you want to be very conservative.
3) Withdraw money from the IRA last. There are a few reasons for this. First, earnings in a 529 savings plan or Coverdell Education Savings account is subject to taxes and possibly a 10% penalty if you withdraw them for something else, so you might as well use them tax and penalty free while you can. Second, having money in non-retirement accounts reduces your child’s financial aid eligibility each year so they might get more aid in future years if you deplete those assets sooner. On the other hand, withdrawals from your IRA are treated as income and can reduce financial aid eligibility so it would be best to take them out in the last year after all the financial aid has already been awarded. Finally, if you end up not needing some of the money for college expenses, it can continue growing tax-deferred for your retirement.
Follow these guidelines and you can have a decent-sized education fund that you didn’t even know you have. It’s like magic. Just don’t expect the same thing to happen for your retirement…