In the unlikely event of a loss of cabin pressure, panels above your seat will open revealing oxygen masks. Reach up and pull a mask towards you… Secure your own mask first before helping others.
If you have ever flown on an airline, you have no doubt heard this speech. When I fly with my children, this means I should put my mask on first and then assist them. The logic is clear: You are of no use to your child if you don’t take care of yourself first. This concept is the analogy I use to speak to my clients, when they ask me if they should dip into their retirement savings, or stop contributing to their retirement, to help fund their child’s college education. Purely from a planning perspective, it is an easy question to answer. But that does not change the fact that it is often an emotional decision.
In the 2018 edition of their annual study “How America Values College,” Sallie Mae and Ipsos revealed that 8 in 10 families believe a college education is more important than ever, and that 83% of people believe they will earn more with a college degree. Using this data, it is fair to say that the majority of parents want their child to attend college; but how will they pay for it?
Over the years—and against my advice—I have had clients dip into their retirement savings to help their children pay for college. This is something I would never recommend. Retirement for most people is a necessity. There are folks who say they will never retire, but for most, there will come a time when they will no longer be working and will need an income source beyond Social Security. While there are many resources to help make college more affordable, beyond Social Security there are no other safety nets in retirement if you have not saved enough money. If you want to be in a financial position to help your children pay for their education, it makes sense to look after your own finances first. The good news is that fewer parents are using their retirement savings to pay for college… and the view on whose responsibility it is to pay for college is shifting as well.
In the 2018 edition of their “How America Saves for College” study, Sallie Mae and Ipsos note that only 10% of those surveyed are planning to use retirement accounts to fund their child’s education—this is down from 20% in the 2016 study. They also note that 59% of those surveyed believe their child should have at least some responsibility in paying for their own education—up from 51% in 2016. Over that same time period, those parents surveyed who believe they are solely responsible for paying for their child’s education has dropped from 30% to 26%. Interestingly, lower income parents are more likely to feel the need to pay for all of their children’s college education than higher income parents. The sad part of this statistic is that those same parents are more likely to dip into their retirement savings and harm their long-term financial independence. Before making the decision to tap your retirement account for college, parents and kids should consider other options that can help lower the cost of college.
Take John and Jane for example. Their daughter Jean will be attending the University of Maryland in the fall. The current cost for tuition for undergrads at Maryland is approximately $27,000 per year. Both of Jean’s parents work and make a good income, so she has not qualified for much in the way of financial aid, though she did receive a $3,000 scholarship for each of her four years. Assuming costs don’t go up, Jean has to come up with the remaining $96,000 over the next four years. John and Jane have not saved for Jean’s education, so they are considering taking the money from their 401ks to fund Jean’s education.
They have two options if they are going to take their money from their 401k accounts, and neither is very good. Option 1 is for them each to take a loan from their 401k. Generally, 401k plans will allow you to take a loan from your plan of up to 50% of your account, up to $50,000. The downside to this is that the loan often can be required to be repaid in 5 years, and certain events—like if you were to leave your employer—could trigger the repayment of the balance immediately. If any of the portion of the loan is not paid back, it is considered a taxable withdrawal. This is generally not an ideal scenario, as most college loans outside of a 401k can be spread out over a longer period of time making it easier to return the borrowed principle.
Their second option would be to take the money out of their 401ks directly. This is even less ideal. In addition to a 10% penalty on the early withdrawal, they would also have to pay taxes on the amount distributed. In their case, to get $96,000 net they would have to withdraw nearly $175,000—including withholding 28% for federal taxes and 7% state taxes. In a $500,000 account, that leaves only $325,000 to earn and grow. In 15 years, at an achievable rate of return on a conservative diversified portfolio of ETFs, or stocks, bonds, and cash, (net of fees and reinvested) that $175,000 could be worth closer to $500,000 had they left it in their retirement plan (or $825,000 in total). By withdrawing this level of capital from their retirement savings, they reduce the account’s ability to generate capital growth of the principle, leaving less to withdraw from in later years, and could do major damage to their retirement plans when there are other alternatives to paying for their daughter’s education.
Some of the creative ways that kids are employing to help reduce their college costs include living at home, working and attending school at the same time, attending an online college or university, going to school part time and taking longer to finish their degree, or delaying their start date and working to save money for school. There are many ways to make college more affordable and to pay for school without dipping into your retirement savings, so this should only be done as a last resort.