Diverting retirement cash to a 529 plan (Script)

Question

Dear Joe, My wife and I have more than $150,000 in Roth IRA contributions in addition to another $300,000 in retirement savings. We have zero in a 529 plan or other college savings. With our first child five years from college, we are concerned that Roth contribution withdrawals may not be a good vehicle for college tuition as the withdrawals show up as income on parent's financial aid even though they're not taxable income. This may affect ability of our child to obtain student loans.We are considering cutting back on our 401(k) investments and saving aggressively in a 529 plan. Thoughts? -- Neal Watch Video

Answer

Number 1: don’t cut back on 401k contributions that your employer will match. That match is a substantial guaranteed return on your investment.

Beyond that amount: not a bad idea to start pumping some savings into a 529 plan. Provided you end up using it for college, the 529 earnings will be tax-free, just like using your Roth IRA in retirements. Plus with a 529 plan, you may be able to deduct some of your contributions on your state income tax return, depending on where you live and which 529 plan you use.

Any way you slice it, your family is going to have to come up with the money for college some how. It could come from your Roth IRA, it could come from a 529 plan, it could come from student loans or parent loans. It probably should not come from borrowing on your 401K because you’ll have to start paying it back right away or face some stiff penalties.

As you obviously already know, withdrawing your Roth IRA contributions can be a good tax-free way to pay for college. The problem is that it can derail any need-based financial aid because the withdrawals have to be reported on the aid application. Withdrawals from a 529 plan do not get reported, although a small percentage of the account value does get reported.

The best outcome is to not use any of your retirement money for college, so that it stays there for your retirement. At the same time, you don’t want your child to graduate from college with a lot of debt, whether or not your child qualified for government subsidized loans. 529 plans help you accomplish these goals.

I know that some advisors might tell you to put every penny possible into your 401K and your IRAs before turning to 529 plans. After all, you can’t borrow for retirement although your child can borrow for college. But I don’t completely subscribe to that theory, especially when your college costs begin in five years and your retirement is sometime in the future. Many parents say that they would rather delay retirement than see their child burdened with a lot of debt, so shifting at least some of your focus from retirement savings to college savings can make sense.