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529 or 401(k)? All in the Numbers for a Child's Future Education

February 19, 2014 By:
Lauren Kramer, Special Sections
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When you have kids, the years begin to flash by in a blur that begins with diapers and moves quickly to college preparation.

For those parents who can afford to save for their kids’ college tuition, the investment options available depend on each family’s personal situation. For some, a 529 plan makes the most sense, while for others, withdrawing from their 401(k) is a more logical step. The one you choose will depend on your financial situation and your kids’ likelihood to attend college.

“It’s a tricky question, which one to choose,” says Michael McCloskey, assistant professor in the Department of Risk, Insurance and Healthcare Management at Temple University’s Fox School of Business. “The 401(k) is essentially a tax-deferring savings tool that allows people to save money for retirement. After age 59½, you can start taking money out and use it for anything you like, including your child’s education, at which point you are taxed at today’s rate of income.”

By contrast, the 529 plan, as long as it is used toward your child’s college education, never gets taxed. Should your child opt out of going to college, you have the option of using the money for something else — but you pay tax on those funds as well as a 10 percent penalty.

“Which plan is better depends on how confident you are that your child will use that money towards tuition,” McCloskey says. “But with the 529 plan, depending on your income tax bracket, you’re saving between 10 and 40 percent in tax shelter benefits. So you have to weigh that against the risk of your kid going to college. If they don’t go, some of the benefits of the 529 are eroded.”

How much money you plan to save will also affect your choice of plan. The two plans have very different contribution limits, says Jacqueline Volkman Wise, an assistant professor in the same department at Temple University and instructor of a course on retirement plans.

In 401(k)s, the maximum annual contribution for an individual is $17,500, not including any employer contributions, and if you’re over 50, you can add another $5,500. But you can put a lot more away in a 529 plan, she says.

That can present a problem if it turns out you don’t need all the money you socked away in your 529 plan, though. “If you don’t use all the money for college, you’ll pay taxes on withdrawals that aren’t used for educational purposes,” Volkman Wise says. “That means, effectively, that you’d be taxed twice, because the money was deposited after tax, and the withdrawal would be taxed too. Parents need to be cautious of not overshooting what they think their kids’ tuition expenses will be, though if they chose to go back to school themselves, the 529 plan funds can be put towards a parent’s” tuition, too.

The right plan for your family will depend, in part, on when you begin saving for your kids’ tuition. “Think about this when your kid is born and you have 18 years to save for college, but if you only start to consider the options when your kid is age 12, you have much less time to save,” she says.

“It’s one of those things where you want to sit down with an adviser to see what your best option is.”

Steve Cagnassola, president of Complete Future Planning in Netcong, N.J., advises his clients not to use the funds in their 401(k) for their kids’ tuition because the cost to liquidate their account or borrow from it can be quite expensive.

“While most parents will qualify for financing for their children’s college loans, there is no loan available to fund their retirement,” he says.

But 529 plans can also be problematic, he warns. “They’re stock market-based, which means they rise and fall with whatever the stock market is doing. They have a propensity to lose value when you need them most.”

That happened to several clients at a seminar Cagnassola gave on college planning in 2009. “Several of the participants informed me that the stock market had ruined their kids’ education savings,” he recalls. “They went from having nearly three years of funding for their kids’ education — almost $150,000 — to losing half of it because of the stock market turn. That meant they only had a year-and-a-half’s” worth of savings “to satisfy their kids’ education.”

A safer bet, in his opinion, is using the Index Universal Life Insurance. “It builds cash values based on changes in the S&P 500 index, which gives parents the ability to save for their child’s education and their retirement at the same time,” he says. “Any gains earned are credited and locked in, so parents cannot lose in the event of a stock market downturn.

“Plus, if a parent or guardian dies prematurely, their family would receive a tax-free, lump sum death benefit, typically 5 to 10 times more than they would receive from the 529 or 401(k) plan.”

Cagnassola says plans are usually custom designed according to clients’ goals, whether focused on saving for their children’s education or for their own retirement. “We build a plan that accomplishes the maximum cash value accumulation while minimizing the death benefit,” he explains. “For example, a female, age 35, who wants to set aside $10,000 for her daughter’s education, could have a face amount of $450,000 and projected cash value of $342,000 at her child’s 18th birthday.”

South African Lauren Kramer is a writer based in Western Canada. This article originally appeared in the special section, "Financial Health."

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