Ever have that nightmare where you realize there’s a final exam the next day, but you forgot to study?
The 1990s version is: Your kid is going to college soon, but you forgot to save. And you have to save for retirement at the same time!
Most people, regardless of income, don’t start to save for college until their kids are in their teens. And a lot of people aren’t having kids until their 30s or 40s, so they’ll be shipping them off to college when they’re heading into retirement.
Luckily, new tax laws create fresh tax breaks for college financing, and new ways to save for college using tax-sheltered retirement plans. Here are answers to some of the most common questions people have about the best way to juggle college and retirement savings:
– Should I save for college first? Then save for retirement?
Save for both at the same time. You can’t afford to postpone saving for retirement for the 10 or 20 years until your child is out of school. With an employer’s plan you get valuable tax breaks that make your money accumulate faster; you might also get a matching contribution from your employer; and, if necessary, you could borrow from the account to pay tuition. As financial adviser Dee Lee, in Harvard, Mass., points out, “They don’t give scholarships for retirement.”
– Should I save in my child’s name?
Many financial wizards claim that putting money in your child’s name means he’ll qualify for less financial aid.
While it’s true that colleges expect a student to use a percentage of his resources, most aid is in the form of loans, not cash awards. So putting all the money in your name instead of your child’s just means your kid could get more loans–and go further into debt.
Meanwhile, if the money is in your child’s name, it will be taxed at her lower rate (the first $650 in unearned income is tax-free; kids over age 14 pay capital-gains tax at rates as low as 8 percent).
– What’s the best way for the child to save?
Consider this new strategy: As long as your child has $2,000 a year in earnings, she could contribute that much to a Roth IRA. The money will grow tax-free, and she can pull out all her contributions tax– and penalty–free (but not the earnings) to pay for college or living expenses. Assuming she saves $2,000 a year for seven years, that’s $14,000 in contributions, which would pay for almost two years’ tuition at a public university and one year at the average private school.
A child with earned income can also contribute and deduct up to $2,000 a year into a regular IRA. (The deduction is available when a person is not covered by a retirement plan.) The money grows tax-deferred, and when the child pulls it out to pay for college, it will be taxed at his or her lower income tax rate (typically 15 percent), yet won’t face the 10 percent penalty for withdrawals before age 59 1/2, because the money is being used for college.
– Can I use a Roth IRA for college savings?
If your income as a couple is $150,000 or less ($95,000 for individuals), you can contribute up to $2,000 a year into a Roth, even if you have a retirement plan at work. You can pull out the contributions (not the earnings) tax- and penalty-free to pay for tuition, living expenses, or anything else. The earnings remain in the account, tax-sheltered, until you’re over age 59 1/2. Then you can pull them out tax-free.
– Should I bother with the new education IRA?
Yes, if you’re eligible. The newly created education IRA, or EdIRAs, lets you contribute up to $500 per child under age 18 each year, provided your adjusted gross income is $95,000 or less, filing single, or $150,000 or less, filing as a couple. If you don’t meet the income qualifications, grandparents or others can contribute to the child’s account, if their income qualifies.
Contributions to EdIRAs aren’t deductible, but the money grows tax-deferred, and can be withdrawn tax-free to pay for tuition, fees, room and board, and equipment needed for enrollment in higher education, such as computers.
Ignore the chorus of critics who complain that the annual amount you can save is too piddly to bother with. It’s better than a poke in the eye, and it’s possible that Congress will increase the contribution limit. Money you contribute to an EdIRA doesn’t reduce the amount you can put into a Roth or other type of IRA. And if your child doesn’t need the money (say, she wins a huge scholarship), then an EdIRA account can be transferred to another member of the family.
– Can I have an education IRA and a regular one?
Yes. Assuming you meet the income limits, you and your spouse can each have a Roth IRA, and can also contribute to an EdIRA. If your child also has a Roth IRA, your family could conceivably be saving $6,500 a year, tax-free.
– What kinds of investments make sense?
For most people, mutual funds are the best choice for college savings, whether in your IRA or a regular account. Stock funds will provide greater returns over time. If you’re saving outside of IRAs, look for “tax-efficient” funds, which generate very little capital gains. And when you sell shares to pay tuition, you’ll pay at the new low capital-gains rate. So they’re virtually the same as tax-deferred accounts.
Avoid using life insurance and annuities to save for college: The high costs erase the benefit of the tax-deferral, especially if your time horizon is less than 18 years. And withdrawals from annuities are 100 percent taxable until your earnings are used up, and face a 10 percent penalty if you’re under 59 1/2. This can cut your withdrawal in half.
– Why bother? We’ll never save enough.
Join the club. Most parents have less than $5,000 saved for college, according to a recent study by Mosaic Mutual Funds. Quit fussing. Take out a home equity loan. Have your kid live at home and go to a junior college for two years, then transfer to Bankrupt U.
Also take a look at the new options that even high-income parents can use: The new Hope Scholarship tax credit lets you take a maximum tax credit of $1,500 per child for tuition during the first two years of college. After that, you can use the new Lifetime Learning Credit to erase up to $1,000 off your taxes each year. The credits phase out if your adjusted gross income is between $80,000 and $100,000, ($40,000 to $50,000 for single filers). But most people who are retired by the time their children are in college should find it easy to qualify.
Similarly, the new law allows you to deduct up to $1,000 in interest on student loans (the amount will increase to $2,500 in 2001 and thereafter). Again, there are income limits to qualify (eligibility phases out when modified AGI is between $60,000 and $75,000 for couples, $40,000 to $55,000 for singles).
But you could be paying off those loans when you’re retired, and your income has fallen. Lucky you.
