The Best Investments for Children and Grandchildren: Consider a 529 Plan instead of Retirement Plan Withdrawals

The Best Investments for Children and Grandchildren: Consider a 529 Plan instead of Retirement Plan Withdrawals
The Best Way to Save for Grandchildren and Children? Consider a 529 Plan After You Take Care of Retirement Savings
The Best Way to Save for Grandchildren and Children? Consider a 529 Plan After You Take Care of Retirement Savings

Many grandparents and parents strive to help their children pay for college. But there are smart — and not-so-smart — ways to assist them.

The gratification of being a grandparent stems from the ability to help shape another generation, according to an AARP survey of grandparents’ insights and spending habits. Part of this gratification comes from helping grandkids pursue educational goals, including attending college.

“We find a lot of parents and grandparents feeling some sort of emotional obligation to pay for college, and they’ll do that at the expense of their own retirement,” says Sarah Swantner, certified financial planner with Kahler Financial Group in Rapid City, S.D.

More than 70% of AARP survey respondents reported that they have spoken to their grandchildren about school or career plans, one of the top issues they worry about most, the survey shows.

But spending significant amounts on children’s or grandchildren’s educations can derail retirement plans and leave older adults with more problems to deal with.

“They could actually be doing more harm than good,” says certified financial planner Debbra Dillon, of Eagle, Idaho-based Dillon Financial Planning. “Eventually, down the line, if they don’t have millions of dollars in their accounts to support a retirement and college, they’re going to end up putting their kids in the position of having to take care of them [financially].”

The Not-So-Smart Way to Fund College Expenses

Many families (21%) made a concerted effort this year to use only out-of-pocket funds to pay for college — including withdrawals from retirement accounts, according to the 2014 Sallie Mae national study of college students and parents.

About 7% of surveyed families said they withdrew money from their retirement savings this year to fund college expenses, with an average withdrawal amount nearing $9,000.

The advantage? Avoiding large sums of student loan debt. The disadvantage? Chipping away at retirement savings that can’t be replaced, plus potentially incurring penalties from doing so.

“Retirement accounts should not be used for anything but retirement,” Dillon advises.

Aside from the obvious fact that taking money from your savings account leaves you with less money to live on during retirement, withdrawing early (before you reach age 59.5) from some accounts may also come with a penalty.

Most retirement plan distributions are subject to income tax and, to discourage the use of retirement funds for purposes other than normal retirement, there is a 10% additional tax on early distributions from certain retirement plans, including a 401(k) and individual retirement account (IRA), according to the IRS.

There are some exceptions to this 10% additional tax, so it’s important to check the fine print on your plan to see if you may qualify for exemption.

For example, there are generally no exceptions to the tax penalty when withdrawing money early from a 401(k) plan to pay for higher education expenses, the IRS says. However, if withdrawing early from an IRA to pay for college expenses, you may qualify for an exemption to the 10% tax penalty.

Doing some research ahead of time can help you better plan if paying for your grandchild’s education is one of your financial goals.

The Smarter Way to Pay for Education Costs

“Start planning early,” Dillon says. “You can’t do anything later on that’s going to be a great choice. You want to have some freedom by starting early to invest for your childrens’ education.”

A 529 plan is a good way to start, she says.

What Is It? A 529 plan is a savings vehicle developed specifically to help parents and grandparents save for college expenses down the road.

These plans, known as “qualified tuition plans,” are sponsored by states, state agencies or educational institutions that are authorized by Section 529 of the Internal Revenue Code.

Prepaid vs. College Savings Plans. There are two types of 529 plans: pre-paid tuition plans and college savings plans.

Pre-paid tuition plans allow the account holder to purchase credits at participating colleges and universities for future tuition and, in some cases, room and board. Most of these plans are sponsored by state governments and have residency requirements.

College savings plans generally allow parents or grandparents to establish an account for a student for the purpose of paying for eligible college expenses. The account holder typically chooses among several investment options for his or her contributions, including stock mutual funds, bond mutual funds and money market funds, according to the U.S. Securities and Exchange Commission.

Research more about the differences between the two types in order to make the right choice for your family.

What Are the Advantages of a 529 Plan?

Withdrawals from the account are untaxed as long as the money is used for qualified education expenses, such as tuition, fees, books and room and board, according to the IRS.

Anyone can set up a 529 account and name anyone as a beneficiary — including a child, grandchild, friend or even yourself — and there is no limit to the number of plans you can set up.

For grandparents, they can either open their own 529 plan or can contribute to a 529 plan that the parents have opened.

“It’s sort of a safe way to plan to help a child or grandchild go to college without committing to it [financially],” Swantner says. “You’re never really giving the money away to the child; you can change the beneficiary at any time.”

Long-term Financial Planning

If paying for a grandchild’s college tuition is a long-term goal, grandparents should consider putting money away in other savings accounts until a 529 plan is opened, Dillon says.

“If grandparents have long-term planning where they know that they want to provide some funding for grandchildren who are not yet born, then their best bet would be to open a mutual fund account — not an IRA — or a simple savings account and put money there until a 529 account can be opened when the child is born,” she says.

Before opening any accounts, though, it’s important to first speak with a financial adviser to determine whether paying for a grandchild’s college expenses is a viable option for you.

“They can help you through the process of looking at your budget, finding out what your needs in retirement are going to be, giving you the answers you need, and [determining] how best to save toward that goal,” Dillon says.