College Q&A: 529 or Retirement?

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Welcome to MainStreet's newest series. Each week, we will answer a real question from readers on education costs and how to pay for college. If you have a question, feel free to send it to editors@mainstreet.com.

Q: "My wife and I are in our mid-30s. We have a high school sophomore, a two-year-old and a nine-month-old. We do not have a college savings plan in place, however, and I am still paying off my grad school loans. That said, we can finally start setting money aside for the future. What's a better approach: Save for the younger kids with a 529 type deal, or put money aside for our retirement first? The financial planners we’ve spoken to argue both ways."

-Joseph, Spring Lake, Mich.

A: Joseph, some financial planners like to draw an analogy from the air safety briefing: Put your own oxygen mask on first before assisting children with theirs. But this analogy is weak at best. Parents are told to put their own masks on first because hypoxia can quickly lead to confusion or unconsciousness. A parent who puts the child’s mask on first might not complete the task correctly, causing both parent and child to pass out. The real goal of the air safety briefing is to ensure that both the parent and child survive.

There’s also a big difference between an emergency situation and long-term planning. It may feel like there’s not enough money to save for both college and retirement, but careful planning can allocate the money effectively.

For example, if you choose to borrow instead of saving, it may ultimately cost you more. Consider that if you are earning 2% on your bank savings account but paying 12% on your credit cards, using the money in the bank to pay off your credit card balance actually helps you save in the long run.

Assume that the return on investment would be the same for college savings and retirement (say 5%). For a moment, let’s pretend that your children will go off to college in 17 years and that you and your wife will retire in 40. Suppose that you can save $250 a month for college or retirement, but not for both. If you save for college until one of your children turns 17 and start planning for retirement later, you’ll accumulate about $82,300 by the time the child enrolls in college and eventually $108,900 in retirement savings. If you save only for retirement, however, you’ll need to borrow the $82,300 to pay for college. Given the current annual loan limits, your child will borrow $27,000 in Stafford loans at 6.8% interest and you’ll borrow the rest in Parent PLUS loans at 7.9% interest. Repaying these loans will cost almost $1,000 a month for 10 years. So, in the end, you’ll accumulate about $93,200 for retirement after repaying the loans, or $15,700 less than if you had paid for college with savings instead of loans.

Of course, if you don’t help your child pay for college at all, you’ll accumulate about $391,900 for retirement.

Since you’re still repaying your own student loans, you should compare the return on investment from saving in a 529 college savings plan with the interest rates on your own student loans. If the loans have a higher interest rate, use the money you would have saved in your children’s 529 plans to accelerate repayment of your student loans. Paying off the student loans saves you the money you would have been paying in interest. Usually this is a better return than your savings accounts.

Always prioritize your savings opportunities and debts according to the after-tax interest rates and allocate any extra money toward the highest interest rate item first. Typically this means paying off credit cards and private student loans first. Of course, if your employer matches your 401(k) contributions, you should maximize the match, as the employer contributions yield a big boost in the return on your retirement plan. Otherwise, you will maximize your finances by using extra income to pay off high interest debt before saving the money in a retirement or college savings plan.

—Mark Kantrowitz is president of MK Consulting Inc. and publisher of the FinAid.org and FastWeb.com. He has testified before Congress about student aid on several occasions and is on the editorial board of the Council on Law in Higher Education.

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