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 Setting Priorities: Making Investment Decisions for Your Family's Future by Carrie Schwab-Pomerantz, CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc. January 31, 2008 Dear Carrie, I have two children (ages 8 and 4) and have set up 529 college accounts for both. My wife and I currently have $500,000 in various retirement accounts. We are both 37 years old and are currently contributing the maximum to our employer 401(k) plans. My question: Which account should we fund, choosing between the traditional IRA ($8,000/year) and the 529 college accounts? I lean toward the 529 since we'll need that money in 10 years, but would like your advice. —A Reader Dear Reader, At its heart, personal finance is all about priorities, and from what you've told me, you've got two primary objectives: a financially secure retirement and college funds for your two children. It sounds like you've made progress toward both goals, but let’s take a closer look. (It seems that you are in the fortunate position of being able to accomplish both objectives, but for our readers who may have to choose between investing for retirement and investing for education, I’d like to interject that I just about always favor retirement. There are lots of ways to get help with college costs, such as grants, scholarships, student loans, part-time work, etc., but funding a reasonable standard of living for retirement sits squarely on each individual’s shoulders.) Your retirement nest egg Let’s first look at where you stand relative to your retirement. Based on the information you’ve provided, I did a quick calculation to see what your retirement savings might become when you turn 62 (a possible retirement age). As a hypothetical example, let’s assume that your 401(k) accounts average a return of 8% per year for the next 25 years, and you continue to contribute $31,000 a year (the current maximum for two people under age 50)—you could turn 62 with about $5.7 million earmarked for retirement. Using our 4% withdrawal guideline, you could then withdraw approximately $228,000 per year starting at age 62 (with that amount growing each year with inflation). And, of course, if you increase your 401(k) contributions as the allowances rise, you’ll have the potential to earn even more. Now $5.7 million may sound like a lot of money (of course, it is a lot of money), but don’t forget the corrosive power of inflation. If we assume an average annual inflation rate of 3% for 25 years, the $5.7 million from this example becomes the equivalent of about $2.7 million in today’s dollars. I'm certainly not saying you aren't prepared; I’m just encouraging you to keep saving and investing. Assets for college So now let’s take a look at your other financial goal: funding your children’s educations—another very expensive long-term goal. I'll start by pointing out just how big that goal could be. According to a report by The College Board, the average cost of one year at a private college (factoring in tuition, fees, books, room and board, and related expenses) runs about $35,000 for the 2007-2008 academic year; for an in-state public college, the average comes to a little over $17,000. Assuming college costs will continue to rise by about 6% annually (the current rate of growth, according to The College Board and given that your two children will probably be matriculating in 10 and 14 years, respectively, you could be facing a total cost (for a private school) of about $294,000 for the older one and $371,000 for the younger one. Schwab’s College Savings Calculator can help you determine the amount you need to invest each month to build toward these goals. Luckily, you've got an ideal opportunity to invest through the tax-advantaged 529 plans you've already established. As I'm sure you already know, contributions to 529 plans are made with after-tax dollars (note, however, that more than half of U.S. states offer current tax deductions to their residents for in-state 529 plan contributions, which potentially makes those plans even more attractive; check with your state's tax authority). Once in the plan, however, the contributions grow tax-free, and you'll never pay tax on the gains as long as the withdrawals are used for qualified education expenses (which include just what you'd imagine: tuition, fees, books, required supplies and equipment, and room and board for students enrolled at least half time1). Obviously, you've got a pretty long time horizon during which you can build some assets for those monstrous numbers, and you should do some calculating of your own to see how much you might have given your current 529 balances, expected future contributions, and projected rates of return. (And yes, the numbers are gigantic. But you've already made a start and you have years to tap the potential growth of the equity markets.) Additional savings So what, in the end, should you do with your extra savings? You really have three choices:
Finally, I want to commend you for two things: First, for your obvious commitment to your financial future—you both are clearly saving and investing aggressively on your own behalf and that of your children. That's fantastic! And second, I applaud your thoughtful approach to financial decision-making. Personal finance almost always involves trade-offs: between current consumption and future investment, but also between and among future investments. Sometimes, determining the vehicle for investing can be as hard as making choices among stocks and funds. These are rarely easy or even obvious decisions, but thinking them through is always the right first step. Good luck! Important Disclosures As with any investment, it's possible to lose money by investing in a 529 plan. Before investing, carefully consider the plan's investment objectives, risks, charges and expenses. Additionally, by investing in a 529 plan outside of your state, you may lose tax benefits offered by your own state's plan. 1. All non-qualified withdrawals are subject to federal and state income tax and a 10% penalty. State tax treatment of earnings may vary. Check with your tax advisor for rules on your state's tax treatment. The availability of tax or other benefits may be conditioned on meeting certain requirement such as residency, purpose for or timing of distribution, or other factors. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction and investment strategy for his or her own particular situation. The examples included are provided for illustrative purposes only and not intended to imply results that you should expect to achieve. The assumptions and data included with these examples are not intended to be predictive of future results. Past performance is no guarantee of future results. Data contained provided by third-party sources is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. The information and content provided herein is general in nature. It is not intended, and should not be construed, as a specific recommendation, or legal, tax, or investment advice, or a legal opinion. Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based upon this information. (0108-3916) Return to Top |
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