Saving Money When College is Not in Your Kid's Future

May 4, 2016

Photo credit:  erikreis - iStock - Thinkstock

In a previous Dime post, I wrote about using a 529 college savings plan to save for your child’s college education. That article highlighted the cost of college and how much you would have to save in order to fund your child’s four years in college. Although a 529 College Savings plan is very tax efficient and well directed plan that is specifically for college savings, the post immediately generated questions about other savings strategies for your kids.

What happens if your child doesn’t want to attend college?

What happens if your child has other needs besides a college education?

What if you just want to put money away in anticipation of having a child sometime in the future?

Are there better ways to save?

First, let’s look at what happens if your child doesn’t want to attend college. The 529 Plan can be redirected to another child in a fairly broad definition of your family. Alternatively, you could use the money for yourself or your spouse to continue the education you always wanted. Finally, the money can be withdrawn for nonqualified expenses and you will pay a 10 percent penalty plus regular income taxed on the investment earnings. This can be a significant haircut but not a total loss.

Some alternative strategies can give you more flexibility, some of the tax advantaged savings, but not the immediate state tax reduction that contributions into a 529 plan receive. Here are some strategies that financial planners have suggested.

Universal Life Policies
A variable universal life policy can be purchased on your life with the child named as beneficiary. The strategy here is to provide a financial cushion should you suddenly die and not be able to support your child and provide for their college education. The value of the life insurance covers your financial liability from the outset of your death. The variable universal life policy also has an internal savings component that increases in value over time. Part of your premium payments fund the savings component of the policy and over time, the cash value of the policy will increase. When the child is ready to attend college you can borrow the cash value of the policy and use this money to pay for college expenses. The advantage of this strategy is that it fully funds your liability now. The internal cash value grows in a tax advantaged manner, and the cash value can be used with greater flexibility for whatever expenses you choose.

An Individual Retirement Account (IRA) or a ROTH IRA can also be used to fund qualified college expenses. Both of these retirement accounts have limitations on the annual contribution amounts so you will have to build up the accounts over time. There are restrictions on the type of expenses that withdrawals can be used for and withdrawals will increase the parent’s expected contributions for financial aid calculations. Keep in mind, financial planners tend to discourage using retirement assets to fund college expenses because it depletes the pool of assets available to finance your retirement.

The savings in a 401(K) plan can be utilized to pay college expenses. But, again, there are several cautionary notes. You can get a loan from your 401(k) plan if your employer’s plan allows loans. There will be restrictions on the size and number of loans that you can get from the 401(k) plan. You will have to pay interest on the loan and. while it is outstanding, you may lose some investment performance in your account.

The biggest risk, however, is that if you lose your job or leave your current employer while the loan is still outstanding, you might not be able to repay the loan when you leave. This would cause the entire amount to be included in your taxable income for that year and you would have to pay a penalty and a tax on the entire balance.

You can also make a hardship withdrawal from your 401(k) to fund education expenses but this will probably result in a penalty, higher taxes, and higher income in the next year’s financial aid calculations. As with the IRA accounts, financial planners discourage using retirement assets to fund college expenses because it depletes your pool of retirement assets.

All of these alternative strategies have a common denominator. They utilize increased amounts of current savings in order to fund a future expense. The 529 plan is specifically targeted to college expenses and has the additional benefit of reducing state taxes on contributions. The other strategies utilize savings that can be used for several purposes but redirected towards college expenses as necessary. There are pros and cons to both approaches. The best idea is to utilize a broad menu of savings strategies that allows you the financial freedom to adapt to changing circumstances and you children’s individual future plans.