Saving for College Versus Retirement

How to balance your golden years with a college fund.

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A debt-free education is probably one of the greatest gifts you can give your child. But a fully financed nest egg will certainly make it easier to sleep at night in the decade leading up to retirement. Ideally, diligent savers are able to fund both college and retirement. But when times are tight, sometimes it feels as if you have to prioritize your savings goals.

Here are some possible ways to balance your golden years with your kid's college fund.

Get the match first. An employer-provided 401(k) match is almost certain to give a better return than any other investment. "I would say save for your retirement first," says Douglas Monaghan, a certified financial planner in Seattle. "With your kid's college, there are a lot of ways to fund it through loans and grants, and when funding your own retirement, there isn't."

Compare returns. Both college and retirement savings accounts should be considered, after maxing out any employer match on your 401(k). "Pick whichever investment is going to yield the best overall return on investments," says Mark Kantrowitz, publisher of financial-aid website "If you've been earning 8 percent on your retirement account and 10 percent in your 529 saving plans, then it is better to put it in the 529 savings plan."

Explore 529 college savings plans. Contributions to a 529 college savings plan compound on a tax-deferred basis and are tax exempt when used to pay for qualified higher education expenses. "Thirty-two states have a state income tax deduction for all or part of your contribution to the state 529 plan," says Kantrowitz, which generally makes state plans a better deal. If you can't deduct contributions, shop around for the plan with the lowest fees. Broker-sold plans may charge annual maintenance fees, enrollment fees, annual distribution fees, and asset management fees that can eat away at the tax savings.

Some states also have prepaid tuition 529 plans that allow you to lock in today's tuition prices at eligible public and private colleges. But it's difficult to know if your 18-year-old will change his or her mind about specific colleges.

Fund your IRA. Some parents crack into their IRA to pay for college. IRA distributions before age 59½ used to pay for education expenses like tuition, fees, books, and supplies are exempt from the 10 percent early distribution penalty. But with traditional IRAs, you still have to pay income tax on the withdrawal. Roth IRA owners pay tax only on the portion of the distribution that comes from earnings because they already paid tax on the contributions. And after age 59½, the entire Roth IRA distribution is tax free if the account is at least five years old. But dipping into retirement funds isn't always the best way to pay for college. "Once you withdraw the money from your IRA, you can't put it back," cautions Kantrowitz. The only way to build up your retirement accounts again is through regular contributions, which are subject to an annual limit of $5,000 in 2008. Plus, you lose out on valuable compound interest as you try to replace the cash.

Consider financial aid. Retirement accounts are a great place to stash cash when your child is applying for federal financial aid. IRAs and 401(k) balances are not counted toward the "expected family contribution" the government deems your family is able pay for college out of pocket. But an IRA withdrawal counts as income for the year, so it could reduce the amount of financial aid your child gets the following year. The home equity in your primary residence, insurance policies, a family-owned business, and annuities also are excluded from your assets when determining the expected family contribution, according to Joe Hurley, a certified public accountant and founder of, a Bankrate website.

For parent-owned 529 accounts, a maximum of 5.64 percent of the balance is factored into the amount the family has to pay for college. Student-owned 529 accounts do not have to be reported on the 2008-09 FAFSA. Beginning in the 2009-10 school year, however, student accounts will also be assessed at the 5.64 percent rate. But the 529 rate is still considerably better than the 20 percent of other assets calculated into the expected family contribution. Also, 529 plan distributions generally don't reduce the student's financial aid for the following year.