Like most things, saving money involves trade-offs. A typical family has a huge number of savings goals that compete against each other, ranging from the immediate needs for back-to-school clothes to longer-term goals such as saving for a young child's college education or for the parents' retirement. Although a combination of frugal living and using money-saving techniques, such as those found in the Motley Fool GreenLight newsletter, can free up some additional money to meet your savings goals, many families still don't have enough free cash to save for everything they'll eventually want or need.
Two main factors can help you decide which savings goals to make a priority. The first and most important thing to consider is what's most important to you from a personal ethical standpoint. If, for instance, you feel very strongly that your children deserve a college education without incurring any student loan debt of their own to pay for it, then no argument based solely on tax or financial planning considerations should sway you from your resolve. As long as you're aware of personal sacrifices that you make and as long as those sacrifices don't come back to impose an even greater burden on the people you're trying to benefit, well-informed decisions based on your own values are often the best course to follow.
However, most financial decisions don't lend themselves to easy decisions based solely on ethics and values, so a second factor becomes critical: the current framework of tax, legal, and financial incentives that the government uses to encourage certain behavior. In considering the specific decision of whether to save for your own retirement or to save for a child's college education, there are a number of incentives to help you no matter which decision you make.
There are many advantages to saving for retirement, especially for those people who have access to an employer-sponsored retirement plan such as a 401(k). Money saved in a retirement plan lowers your taxable income, thereby immediately saving you up to 35% in federal income tax, plus an additional amount in state income tax, depending on where you live. Moreover, many employers provide matching contributions to those employees who voluntarily choose to save a certain amount in the retirement plan. These matching contributions essentially represent free money for the employee. On top of all that, some savers are also entitled to a federal tax credit that provides even more tax savings for those who make contributions to an IRA or employer-sponsored retirement plan. Eligibility for this tax credit depends on your total income, but for those who qualify, the credit represents an additional match to your retirement savings.
There are also further benefits to money saved for retirement. Savings in an employer plan or IRA grows on a tax-deferred basis, which means that you pay no tax on the interest, dividends, or capital gains on your retirement account until you withdraw money from the account. Furthermore, in considering the appropriate contribution for parents to make for a child's education, many financial aid offices do not treat amounts held in the parents' retirement accounts as available for spending. As a result, contributions to a retirement account may actually improve your child's financial aid package.
Of course, there are also incentives to save for your child's education. A number of different ways to save for education are available, including qualified tuition programs, also known as 529 plans. These plans provide for tax-deferred growth that becomes tax-free as long as the money is spent on educational needs, and some states provide additional tax savings to families who make contributions. Education tax credits such as the Hope and Lifetime Learning credits provide a partial match on money parents spend toward education.
Many parents believe that saving for education is just a waste of money. The financial aid system, they feel, rewards children whose parents save little or nothing for education while penalizing families that take responsibility for providing money to help pay for educational expenses. Although there is considerable merit to this belief, it's important to keep in mind that financial aid packages have generally deteriorated in recent decades. Packages that used to include substantial grants and scholarships have largely given way to student loans. Far from being free money, these loans often put an insurmountable burden on students at the most critical time of their financial lives and force students to make decisions that sacrifice their true ambitions to the pragmatic necessities of making enough money to climb out of debt. Parents who spare their children from the full brunt of this increasingly common dilemma provide a big advantage to their kids at a time when it's most valuable to them.
So how should you save?
Because there are incentives both to retirement savings and to education savings, most families should try to direct part of their savings in both directions. Employees who are eligible for employer matching contributions should strongly consider saving at least enough in their retirement plans to take full advantage of the match. Families who live in states that give tax incentives to participate in 529 plans may wish to direct additional contributions to obtain those tax benefits. If additional money is available to save, parents should look closely at the amounts they have already saved for retirement and education and then earmark the remaining funds toward the greater need.
If, after considering all of these factors, you still can't decide, consider one final idea: You'll have an entire lifetime to help your children out. If you don't have enough savings to help your kids before they go to college, you may have more savings later on to help them pay off student loan debt after they graduate. However, if you don't have enough money to retire, it's often too late to do anything to fix things for yourself. As long as you can find some way to let your children get the education they'll desperately need for their future, making retirement saving a priority is a trade-off that will give your children the peace of mind of knowing that their parents will be able to take care of themselves.
Here at the Fool, we're committed to helping you prepare for both events. For tips on saving for retirement, click here for a free trial to our Motley Fool Rule Your Retirement service. To save for education, you'll find helpful advice at GreenLight, our new personal finance service. Click here for a free trial to that.
For more educational Foolishness:
- Get Your Kids to College: Introduction
- Get Your Kids to College: Coverdell ESAs
- Get Your Kids to College: Custodial Accounts
- Get Your Kids to College: 529 Plans