Paying off debt versus a 529 plan

Question

Dear Joe, I have a question regarding starting a 529 account for our daughter. Instead of starting a separate college account, we paid off all our credit cards, maxed out 401(k), maxed out our IRA and are currently paying extra on our mortgage to pay the house off by the time she is 13 and having 6 months cash in the money market account. Would you advise if this strategy is correct compared to putting the money in a separate college fund? We thought this way we will have house paid for and have a savings cushion if we ever need to finance her college. -- Alex

Answer

Dear Alex,

What you are describing is a viable college savings strategy. If everything plays out as you hope, you'll be in a comfortable position when your daughter turns 13, and with the mortgage paid off, the extra cash flow can then be directed into a 529 plan or other appropriate investment. Once your daughter gets to college, you can use a home equity loan to help fund that education, along with your savings and possibly some student loans.

The added benefit of home equity as a source of college funding is that your home value will not be counted in determining your daughter's eligibility for federal financial aid. (Your retirement accounts will not count against her either, but be careful about taking any distributions from retirement accounts as they are included in "base year income" and will reduce eligibility in the next year.)

In spite of all that, I would argue that you are probably better off maintaining your regular mortgage payments and putting at least some of the extra cash into a 529 plan or Coverdell Education Savings Account. Let's assume the interest rate on your current mortgage is 6 percent. If you are in the 25-percent tax bracket and can itemize your deductions, the after-tax cost of that interest is only 4 percent.

Can you achieve greater than a 4 percent annual return in a 529 plan or ESA? Most likely you can, but you might have to keep some of your portfolio in stocks to do so, which presents some market risk. The savings from prepaying your mortgage is essentially risk-free.

Or is it? When it comes time for you to take out a home equity loan to pay college costs, the interest-rate environment might not be as favorable as it is right now, and you could end up with a higher interest cost. Also consider that the income-tax deduction for home-equity interest is subject to a $100,000 loan cap. To the extent you can claim the interest deduction, you are increasing your chances of being stuck with the alternative minimum tax.

Another reason to start a separate college savings plan, even if only for a small amount of money, is that it instills budget discipline. You sound like a fairly disciplined person, but for many families the practice of making regular contributions to a college savings plan increases the odds the money will be there once the tuition bills begin to roll in.