529s Shouldn't Be Parents' First Financial Step

529 college savings plans are the best method most families have to save money for higher education expenses, delay or eliminate taxation on future earnings, and still maintain control over the assets.

But the relatively short investment time frame college savers usually have, combined with the possibility of lower net returns during the “accumulation” period, means that families hoping to outrun rising college costs may be disappointed.

So before you start putting parents' money into 529 college savings plans, you should discuss several steps that address more urgent issues, and may offer greater advantages.

1. Prepare For the Worst

   The untimely death of one or both family breadwinners can leave the survivors with a lack of enough money to cover basic living expenses, much less a five- or six-figure future college bill.

   The most cost-effective way to address this deficit is using term life insurance policies that last at least until the children are (hopefully) old enough to care for themselves.

   The amount of the death benefit should be enough to allow the remaining family members to be financially independent, and policies should be obtained on both working and stay-at-home parents.

   Of course, the parents wouldn't want a sum of money this large to be inherited directly by their orphaned children, especially when the kids are “adults” in name only.

   So the parents should consider adding a trust to the will, with guardians and powers of attorney they have established with the help of a qualified estate planning lawyer.

2. Ramp Up Retirement Savings

   Many well-meaning families put near-term college expenses ahead of the farther-out goal of retiring comfortably. But this is usually a short-sighted mistake for several reasons.

   First, it's possible to borrow money to pay for college, and often at favorable terms. But no lender is ever going to offer a “retirement loan.”

   The immediate tax benefits of saving in a 401(k) or IRA are also much larger than anything provided by depositing money into a 529 college savings plan.

   Also, assets accumulated in retirement plans don't measurably reduce the need-based financial aid packages awarded by most schools, especially when compared to other types of savings vehicles.

   But parents who attempt to save for retirement while their children are in school (and applying for financial aid) will likely have the amount they're trying to set aside in retirement accounts added back into the “expected family contribution.”

   If the parents do eventually end up with extra money in retirement, they can use any surplus to make payments on (or pay off) any higher education loans the children have obtained.

3. Pay Off “Bad” Debt

   According to CreditCards.com, in September 2011, the average interest rate charged by credit card companies was 14.94 percent, the highest figure charted by the site since it first began tracking the number in 2007.

   If parents have any of this high-interest debt outstanding, paying it off saves them a cost that will likely exceed anything they could expect to earn in a 529 savings plan sub-account.

   The resulting reduction in savings may also increase the family's eventual need-based financial aid package, as well as bump up the parents' credit score.

   Which will come in handy when the parents go to …

4. Max Out the Mortgage

   Clients who are fortunate enough to have a good credit score and untapped equity in their home can ensure a much happier financial future for their family by taking out a new 30-year, fixed-rate mortgage for as much as the lender will allow.

   For starters, the clients will be borrowing against a home valuation that may not be higher for a long time, if ever. The loan terms are also likely to never be better for the borrower, either.

   Naturally, the 4 percent interest rate currently available on 30-year mortgages is also unlikely to be seen again — especially on a loan that features interest that may be tax-deductible to the borrower.

   Any mortgage proceeds netted out by the homeowner, or money saved via a new, lower monthly payment, can be redeployed towards several strategic destinations.

   Those goals might include paying the premiums on the aforementioned life insurance, or using the extra funds to make up any deficits in monthly cash flow that are created by the increased at-work retirement plan contributions.

5. Fund the Kid's Roth IRA

   Since the parents of high schoolers have only a couple of years left to save and invest before their child starts college, it's difficult to see how money put into a 529 plan at this point can grow substantially, especially if it's invested conservatively.

   Therefore, parents of working teenagers may be able to get more bang for their bucks and their kids by instead setting money aside in Roth IRAs for their children.

   The child has to have legitimately-earned income to be eligible for the Roth IRA. But she doesn't have to put her own money into the account — her parents (or anybody else) can make the deposit, as long as the benevolent depositors recognize it's an irrevocable gift to her.

   Of course, the contributions can be withdrawn at any time for any reason with no taxes whatsoever. So if she needs the money for college, or a down payment on her first house, or just to cover living expenses, only the “earnings” portion of the account will be subject to taxes and penalties.

   But if she can leave the account alone, the payoff in retirement could be astounding. Say a 15-year-old makes $5,000 each year for the next three years, and ends up with $15,000 deposited into her Roth IRA.

   If that money grows at a hypothetical annual return of, say, 7 percent, by the time she's 65 the $15,000 would be worth about $413,000 — tax free.

   Trying to reach that same figure by saving later in life would require her to make $5,000 annual contributions to a Roth IRA from age 38 to 65 — a total of $135,000.

   And if you can make that point clear to the teenager, you will not only earn the gratitude of the parents, but provide the most valuable education she may ever receive.

WRITER'S BIO:

Kevin McKinley CFP is Principal/Owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book, Make Your Kid A Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. Find out more at www.mckinleymoney.com.