Ask Money

College savings

Chris Farrell Aug 9, 2010

Question: I follow all your shows and blogs: I find them the best source for all money-matters. I contribute the maximum allowed by the IRS for my 401k, the maximum as traditional IRA for my wife (does not have a company sponsored 401k), and have about $25k in an emergency savings account that we’d like to increase. Up to now we have not started to think about college saving for our two children (already 10 and 8 years old) and I am a bit worried. I have the following dilemma: invest part of the emergency savings into a Roth IRA on my name or start a 529 college savings plan to benefit my kids? Can contributions to a 529 college savings plan be withdrawn without penalty (similar as for the Roth IRA)? Or would a better option to maintain flexibility (as suggested in some of your posts) to invest the emergency savings in some long-term bond index fund? Thank you very much in advance. Andrea, Seattle, WA

Answer: I’m glad we’re useful to you in money matters. It’s really good to hear that we’ve been helpful. On your question about contributions and a 529 plan the analogy to a Roth is spot on.

You’ve already paid federal taxes on the contributions. So, like a Roth, you can take out contributions free of federal taxes and without paying a penalty. (You would pay taxes and penalty on any gain if the money is withdrawn and doesn’t go toward qualified education expenses.) Depending on your state, you might owe the local IRS some money if you got a state tax break on the contributions into the 529.

In other words, it’s much like a Roth. There’s even a good argument that in a serious bind it’s better to tap 529 contributions than the Roth money. The reason is that your student has a lifetime to pay back student loans. But you’ll need the Roth money during retirement. And that’s probably within a relatively short time frame.

Still, I would encourage you to focus on building up a margin of safety for your household first. You can always draw on those emergency savings to help defray the cost of college later on. I like the idea that college is simply part of an automatic savings program. Some of your automatic savings could go into a savings account and some of it into certificates of deposit and similar safe investments. You could also consider regularly investing money in a broad-based stock index fund, such as the Wilshire 5000, the Russell 3,000, or the Standard & Poor’s 500. You could load up on tax-deferred inflation-protected I-bonds for the fixed income portion of your portfolio.

The mix of secure and riskier savings accumulates over time. It may be tapped without worrying about penalties to fund a career change, a medical emergency and, yes, college tuition. This approach leaves you with a lot of financial flexibility.

However, you could leaven it with a valuable tax break. The minimum contribution in most state-sponsored 529 plans is around $25 to $30. So, you could put small sums of money into a 529 for your children while focusing most of your extra money into overall savings.

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