Saturday, April 23, 2011

Where to Allocate Savings: 401K vs. Roth 401K vs. 529 College Savings Accounts

For those who are reading this and unfamiliar with what a 401K is vs. a Roth 401K vs. a 529 College Savings Account, descriptions are at the bottom of this blog post.

A friend of mine saw that I have the UPromise credit card and complimented me on using the credit card.  It lead to a more extensive conversation about saving for college for his daughter.  I asked him the question of whether he was maxing out his 401K first prior to his monthly contribution to the 529 College Savings Account.  The answer was no.

I asked him why not?  He replied that he needs the money to pay for his daughter's college first since that'll come before he retires.  Smart logic?  In theory yes, but you should be able to guess that the answer is no, otherwise why bother to write this blog commentary.

The smarter strategy for most people is to max out their 401K (preferably a Roth IRA over a traditional IRA in most people's cases) before saving for their kids college.  Why? A few different reasons
  • Colleges will count the 529 savings toward their financial aid packages.
  • Roth IRA's are taxed at current tax rates rather than future tax rates, and most people say that future tax rates and the tax brackets that you'll be in at retirement are likely higher than the rates currently being paid.
  • Maybe your kid will get a scholarship for college and you won't need the 529 - not likely, but one can hope.  With programs such as Income Based Repayment for student loans, it's ideal to let your child rack up debt with the government's assistance and then only pay a portion of it back.
  • If your child works for the government or non profits post college, then they have a lot of repayment assistance programs out there, so it may not make sense to pay for college out of pocket if Uncle Sam will pick up the tab ultimately for you.
Those are just some of the reasons to take care of saving toward your retirement first and worry about your kid's tuition second.  I'll go into more detail on the above topics and details about some of those programs mentioned above in other posts, and feel free to ask any questions that you'd like answers to or for explanations.

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