Perhaps the most frequently asked question we get is how to balance saving for retirement and college. And I can’t answer that in a blog post because the right way to balance depends on your specific circumstances. We have told clients to pause retirement savings to meet college years cash flow needs, we have told clients to stop funding college and focus exclusively on retirement, and everything in between. What I can do is help you to understand how retirement savings impact college.
Once money goes into a retirement account, it’s off the table as an asset for EFC purposes on both the FAFSA and CSS Profile. So the first trick for minimizing assets is funding retirement. Of course, the tax benefits of IRA and 401k contributions make that even easier.
In FAFSA (or Profile) years, pre-tax retirement contributions impact income in two ways. First, you need to add back your pre-tax contributions to your income for purposes of calculating EFC. Second, because you get a tax deduction for those contributions, your actual taxes paid go down which increases your EFC. A family in the 22% tax bracket who puts $10,000 into pre-tax retirement savings would get a tax savings of $2,200 and an EFC increase of $1,034. So for families eligible for need-based aid, almost half the tax savings from pre-tax retirement contributions are offset by EFC increases. If that family used a Roth IRA instead, they would lose out on the tax savings but also lower their EFC, making the net cost of Roth contributions (or the net benefit of pre-tax contributions) quite a bit less.
The AOTC and Lifetime Learning tax credits are based on AGI and are claimed during the college years. For many families, retirement contributions can be used to reduce AGI below the $80,000/$160,000 threshold for claiming the AOTC in 2019. For example, 50-year-old married parents who are both covered by a 401(k) at work can reduce their AGI by up to $50,000 through retirement contributions. Suppose that family has income of $180,000 and two college students. By contributing $20,000 to their 401(K), they would bring their income down to the $160,000 threshold. Their total federal tax savings for $20,000 of 401(k) contributions would be $4,400 in tax savings + $5,000 in AOTC credit = $9,400, meaning they received nearly 50% tax savings for their contributions. Plus, the AOTC and LLC are added back in the FAFSA’s Additional Financial Information section, meaning the tax savings don’t result in an EFC increase. This family would have done well to increase Roth contributions in the pre-college FAFSA years to minimize EFC and then switch to pre-tax contributions in the college years to reap the full benefit of the tax credits.
Many advisors guide parents to use Roth IRAs as “backdoor” college savings accounts because Roths keep assets off the family balance sheet. Remember, though, that distributions from Roth IRAs get the same FAFSA treatment as pre-tax 401k contributions: they’re added back to income if they’re taken out during a FAFSA year. So a family that saved $20,000 in a Roth IRA, rather than a 529, intending to spend $5,000 from it each college year would see their EFC reduced by $1,120 upfront (5.64% of $20,000), but increased by $2,350 (47% of $5,000) in each withdrawal year. And they’d lose out on compound growth of that $20,000 for another decade or two before retirement.
As the above illustrates, there isn’t a single retirement-vs-college savings strategy that works for everyone, or even every year for the same family. Rather, by understanding how the different elements work, you can maximize the benefits to your family.
And truly, for middle- or upper-middle class families, the question isn’t whether to save for college or retirement, but how to save for both. Too many people approach college with the mistaken notion that they’ll get more aid if they don’t have any savings. Savings play too small a role in the formula– and too few colleges meet 100% of need (and those that do meet “demonstrated need,” not perceived need)– to skip college savings entirely.