New Baby? Before You Start A College Fund, Max Out Your 401k

448750235_adfe809b8d_o

Nothing – and I mean nothing – will change your life as dramatically as the birth of your first child. It’s a wonderful experience and one that I hope everyone gets to experience. But it will turn your life upside down.

That chic apartment downtown no longer makes sense… nor does that sporty two-seater car. And enjoying that cappuccino on your patio after sleeping in late on Saturday? Yeah, maybe you can do that again in 18 years.

But perhaps more than anything, starting a family changes your financial priorities. Suddenly, you have expenses you never knew existed… and that massive looming liability of college education.

I routinely get questions from clients and prospects about financial priorities following the birth of a child, but without a doubt this is the most common:

Should I start a college fund?

Absolutely. You should start a college fund. But only after you have already maxed out any 401k or IRA contributions for the year.

Educational Savings Accounts (“ESAs”) and state 529 plans are fantastic ways to save for college. Your dividends, interest and capital gains grow tax free, so long as you eventually use them for college expenses. But unlike a traditional IRA or 401k plan, you get no tax break for the contribution itself.

But here’s the dirty little secret: IRA funds can be withdrawn penalty free to pay for the educational expenses of a child. If it is a traditional IRA, you would have to pay taxes on any withdrawals, though not penalties. And with a Roth IRA, you would only be subject to taxes on the portion of the withdrawal that was considered earnings.

401k funds cannot be withdrawn penalty-free for educational expenses (unless you are age 59 ½ or older). But you can roll your 401k balance into a Rollover IRA and then used those funds, penalty-free, for your kids’college expenses. And while I don’t generally recommend borrowing against your retirement plans, this may also be an option for you and would have the added bonus of not incurring any taxes.

But if ESA and 529 balances can be used tax-free, isn’t that still better than using IRA money?

Based on taxes alone, yes. But there are other factors to consider. To start, you know you need money for retirement. This is an absolute certainty… as certain as death and taxes. But your son or daughter may or may not need money for college. They may get a scholarship… or may choose to forgo college and start their own business, join the military or, for all you know, join a roving carnival circus. And at the rate things are changing, who knows if going to college will make economic sense 18 years from now or if, as is the case in most of the rest of the developed world, a university education becomes “free” in the same sense than public high schools are free today. (Ok, “free” means funded by the taxpayers – you and me – but you get my point.)

The fact is, there are a lot of unknowns when it comes to educational expenses, so it makes sense to prioritize your savings in your retirement plans first. Once you’ve maxed out your 401k plan for the year (currently $18,000 in salary deferral) and taken advantage of any employer matching, save that next marginal dollar in an ESA or 529 plan. Both are fine savings vehicles. But again, they only make sense once you’re exhausted your tax-advantaged retirement options.

Naturally, the usual disclaimers apply here. You should discuss your specific tax situation with your financial advisor or tax advisor before making any major decisions.

Charles Sizemore is the principal of Sizemore Capital, a wealth management firm in Dallas, Texas.

Photo credit: Todd Ehlers