Retirement Tip: Max Your 401(k) Before Your Kids’ 529 Plan

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You’ll have to excuse me while I brag a little. My daughter Gabriela was born on Thursday and just came home from the hospital on Sunday. Mother and baby are doing great!

My house is total chaos at the moment, serving as a nursery, an office and a school for my two sons who are stuck doing remote learning for a while. It also appears to be a soccer training camp, judging from the cones, hurdles and soccer balls scattered across the backyard. But hey, we’re making it work.

At any rate, if you know me, you’re aware that I’m the planning guy.

So I’m already reviewing college savings plans for my little girl. The college-plan landscape is a bit of a mess to navigate. We’ll cover some of the highlights.

If you have young kids or grandkids, or have friends who do, you’ll want to read this.

What Are 529 College Plans?

college savings plans 529 college plansThere’s not really a “right” way to save for college. Savings are savings. A dollar in the bank spends just as well as a dollar stuffed under your mattress.

But one of the most popular ways to save is via a 529 savings plan. Each state has one or multiple plans. You don’t have to choose the plan from your state. But if you have a state income tax, that’s often your best option. Contributions are usually tax-deductible at the state level (though not at the federal level).

A 529 plan looks and feels like a 401(k) plan. Each plan has a menu of fairly generic mutual funds to choose from.

As I mentioned, you get no federal tax break for making contributions. But all of the dividends, interest and capital gains are tax-free, so long as the proceeds are used for qualified educational expenses.

And if your kid doesn’t use the college savings, no problem. You can transfer the funds to a sibling or even a first cousin without tax consequences.

Rule of Thumb for College Plans

I have a rule of thumb here: If your kid is 10 years away from starting college, I think a 529 plan makes sense. You have a long runway to ride out any market volatility and 10-plus years of tax-free compounding.

But the closer your kid gets to college age, the less this makes sense. If you’re only a few years away, you won’t get a lot of that compounding. It makes more sense to keep the money in an old-fashioned savings account. That gives you more flexibility to use the savings on non-school expenses, such as a car.

I’m done contributing to my 10-year-old’s college fund. Additional savings at this point will go into a taxable brokerage account. I’m still contributing to my 7-year-old’s plan, but only for another couple of years.

Because little Gabriela has a good 18 years before college, I plan to save aggressively in hers.

Before You Start…

Remember the pre-flight safety video where they tell passengers to put on their own oxygen mask before putting on their kids’ masks?

The same rule applies to saving. Don’t bother with a college savings plan unless you’re able to comfortably max out your 401(k) or other retirement plan first.

There are a couple of reasons for this:

  1. You have no idea what college will look like years from now or if you’ll need to pay for it. Your kid might become a beatnik street musician and never go to college. Or maybe they get a growth spurt and win a basketball scholarship. Or maybe the entire college model breaks down and we all get free Harvard degrees online.
  2. More philosophically, you’re doing your kid no favors if you pay for their college but have no retirement savings of your own. Sure, they might get out of school debt-free, but they’ll end up having to take care of you in your old age. It’s better to take out loans for your children if you need to. You can even help them pay off the loans if you’re financially able.

The bottom line is: You have to take care of yourself first.

You’ll have to excuse me now. It’s my turn to feed the baby!

Money & Markets contributor Charles Sizemore specializes in income and retirement topics. Charles is a regular on The Bull & The Bear podcast. He is also a frequent guest on CNBC, Bloomberg and Fox Business.

Follow Charles on Twitter @CharlesSizemore.

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