Families paying for college: A mutual approach

By Shelly Gigante
Shelly Gigante specializes in personal finance issues. Her work has appeared in a variety of publications and news websites.
Posted on Aug 16, 2017

For most families, paying for college is a major commitment that involves piecing together a combination of savings tools, including 529 plans, taxable investments, financial aid and, in some cases, even permanent life insurance.

Results from the MassMutual College Savings Study found the average family expects to utilize multiple methods to fund their child’s college. Many, too, place high hopes on scholarships and expect their child to contribute through part-time jobs or loans.

That includes parents like Danijel Velicki, a financial advisor with Opus Group of Virginia in Virginia Beach, Virginia, who can afford to cover tuition costs in full. Why? They want their kids to have some skin in the game.

“We are saving for my kids’ tuition, but we’re also going to make them get scholarships, grants and loans,” said Velicki, noting he observed too many peers during his college days who got a free ride from mom and dad and took it for granted. “Half of them didn’t graduate, or even go to class.”

For his own kids, Velicki said he will require them to take on student loans, and he will help pay for those loans only if they graduate. “If they don’t graduate, that debt is on them,” he said. 

Such strategy serves another purpose as well: It gives him four more years to invest in taxable savings accounts, and potentially build cash value in his life insurance policy, both of which he intends to use to help his kids pay off their final student loan bills. (Money in his 529 account will be used to immediately offset some of the college cost, since 529 funds must be used to pay qualified higher education costs in the same calendar year the expense was incurred.)

“If I have $100,000 saved when they start college, I could have $125,000 by the time they graduate 5 years later just because of the growth of my principal in my brokerage account,” said Velicki. “The growth alone could potentially pay for half or more of their tuition, rather than spending it all on day one and losing that opportunity.” (Related: 529 Strategies)

Because permanent life insurance enables policyholders to access their cash value for financial needs during their lifetime, including tuition, Velicki said such policies are a potentially good way for college savers to diversify.

“I started to appreciate cash value life insurance during the recession in 2008 when cash value worked when nothing else did,” he said.

Take note, however, that access to cash values through borrowing or partial surrenders will reduce the policy’s cash value and increase the chance the policy will lapse. If this happens, it may result in a tax liability.

Rob your retirement?

Ultimately, though, whatever college funding strategy you choose should not come at the expense of your own financial well-being.

Financial advisors generally agree that tapping your tax-deferred 401(k) account or IRA, in all but the most dire of circumstances, can seriously compromise your long-term financial stability – which does no one in your family any favors.

“Your kids can always take student loans or apply for a scholarship for college, but you can’t borrow money for your own retirement,” said Velicki. “People forget about the value of compounded growth, which only happens with time. You can save more for your retirement as you age, or potentially increase your rate of return, but you can never create more time.”

Velicki adds that the greatest gift parents can give their kids is to provide for their own retirement needs first, thus ensuring they don’t become a financial burden later on.

Yet, a surprising number of families still prioritize their kid’s college education at the expense of their own retirement savings.  

Results from the MassMutual College Savings Study reveal one-fifth of families who expect their kids to obtain a college degree will rely on their retirement savings as a top strategy for paying the bills.

Some 43 percent of respondents, the study found, indicated paying for higher education was among their top three financial priorities, just behind the desire to have a stable source of income (44 percent) to provide for their loved ones in the event of an unexpected emergency.  (Calculator: How Much Do I Need to Save for College?)

Interestingly, only 19 percent indicated that one of their priorities was to avoid becoming a financial burden for their family.

Early withdrawal rules

Of course, despite the inadvisability in most cases, there are ways to tap retirement accounts for college.

As a general rule, the IRS allows taxpayers to take early distributions from their IRA to help pay for college without incurring a penalty. Taxpayers may still owe income tax on part of the amount distributed, but the 10 percent penalty that would normally be assessed for those who withdraw money under age 59-1/2 would generally be waived if used for qualified higher education expenses incurred by the IRA owner, their spouse, their child, or their grandchild .

Early withdrawals from a 401(k), 403(a) or 403(b), on the other hand, are subject to income tax, plus the additional 10 percent penalty, with no exception for higher education  expenses.

That could make tapping a retirement account for college expensive. Parents looking to use retirement funds for college, however, can potentially avoid the tax hit (at least until they reach retirement age) and the penalty by taking a 401(k), 403(a) or 403(b) loan instead, if their plan allows.

The IRS indicates the maximum amount the plan can permit is 50 percent of your vested account balance or $50,000, whichever is less.

Such loans must be repaid within 5 years, with interest (that goes back to your account). Take note, too, that any outstanding retirement plan loans must generally be repaid in full if the employee leaves or loses their job.  Failure to do so normally results in a 10 percent early withdrawal penalty on the amount not repaid, on top of the federal and state income tax they will owe.  

But, weighed against the short term pressure of college costs, a loan from your 401(k) can seriously undermine your ability to make ends meet during retirement. (Calculator: How much do I need for retirement?)

Not only will you forgo the compounded growth on those dollars during the years your loan is outstanding, but your plan may also not permit you to make new contributions until the loan is repaid. If you are not making any pretax contributions, your income taxes may rise during those years as well.

Using the 401(k) loan calculator on personal finance website Bankrate.com, a $20,000 loan from your 401(k), assuming a 5 percent interest rate and 7 percent rate of return on your 401(k) investments, would cost you $7,841 over the course of 5 years – if the loan is repaid on time. Failure to repay in 5 years, which would result in a tax bill and a 10 percent penalty, brings the loss to more than $288,000 due to unrealized earnings, for someone with a 35-year time horizon until retirement.  

You can still help

Remember, if you aren’t positioned to give your college-bound kids a free ride, it’s OK. There’s still much you can do to help.

Parents can research ways to cut the cost of a degree down to size, helping their kids minimize the debt they incur.

They can expose their kids to different career options and create opportunities to speak with or even shadow professionals in the fields in which they have expressed an interest. They can help their kids research schools that might be a financial and academic fit, and they can help them fill out the application for federal financial aid to ensure they get the best package possible.

Arming your kids with a sense of direction is highly underrated, said Kathryn Hauer, a financial advisor and author of “Financial Advice for Blue Collar America.”

“A four-year college is a great choice for many, but I’m an adjunct professor and I see an awful lot of students in college without a real plan for the degree or the job they eventually want,” she said.

Many rudderless students end up quitting after a two or three years, saddling themselves with huge loans they still have to pay back but without the future earnings potential to do so. “The financial consequences of being undecided can be really crippling,” said Hauer.

All parents want what’s best for their kids, and for many that includes a college education. But the tuition assistance you provide should never compromise your own financial security.

“It’s simple math,” said Velicki. “If you save for retirement, plus a little extra for college, you can help your kids pay off their loans to the extent you are able and that’s not going to impact your life. But if you stop saving for retirement and put $500 a month into a college fund, that’s going to be a huge opportunity cost to your future.”

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The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel.