Dear Liz: My husband and I have been putting 5% and 6%, respectively, into our 401(k) accounts to get our full company matches. We’re also maxing out our Roth IRAs.
The CPA who does our taxes recommended that we put more money into our 401(k)s even if that would mean putting less into our Roth IRAs. We’re also expecting our first child, and our CPA said he doesn’t like 529 plans.
What’s your opinion on us increasing our 401(k)s by the amount we’d intended to put into a 529, while still maxing out our Roths, and then using our Roth contributions (not earnings) to pay for our child’s college (assuming he goes on to higher education)?
Our CPA liked that idea, but I can’t find anything online that says anyone else is doing things this way. I can’t help but wonder if there’s a catch.
Answer: Other people are indeed doing this, and there’s a big catch: You’d be using money for college that may do you a lot more good in retirement.
Contributions to Roth IRAs are, as you know, not tax deductible, but you can withdraw your contributions at any time without paying taxes or penalties. In retirement, your gains can be withdrawn tax free. Having money in tax-free as well as taxable and tax-deferred accounts gives you greater ability to control your tax bill in retirement.
Also, unlike other retirement accounts, you’re not required to start distributions after age 70 1/2. If you don’t need the money, you can continue to let it grow tax free and leave the whole thing to your heirs, if you want.
That’s a lot of flexibility to give up, and sucking out your contributions early will stunt how much more the accounts can grow.
You’d also miss out on the chance to let future returns help increase your college fund.
Let’s say you contribute $11,000 a year to your Roths ($5,500 each, the current limit). If you withdraw all your contributions after 18 years, you’d have $198,000 (any investment gains would stay in the account to avoid early-withdrawal fees).
Impressive, yes, but if you’d invested that money instead in a 529 and got 6% average annual returns, you could have $339,000. At 8%, the total is $411,000. That may be far more than you need — or it may not be, if you have more than one child or want to help with graduate school. With elite colleges costing $60,000 a year now and likely much more in the future, you may want all the growth you can get.
You didn’t say why your CPA doesn’t like 529s, but they’re a pretty good way for most families to save for college. Withdrawals are tax free when used for higher education and there is a huge array of plans to choose from, since every state except Wyoming offers at least one of these programs and most have multiple investment options.
Clearly, this is complicated, and you probably should run it past a certified financial planner or a CPA who has the personal financial specialist designation. Your CPA may be a great guy, but unless he’s had training in financial planning, he may not be a great choice for comprehensive financial advice.
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Dear Liz: My spouse has tenure at a university. Given that one of us will always be employed, should we change the way we look at the amount of money we keep in an emergency fund or our risk tolerance for investments?
Answer: Even tenured professors can get fired or laid off. Tenure was designed to protect academic freedom, but professors can lose their jobs because of serious misconduct, incompetence or economic cutbacks, such as when a department is eliminated or a whole university is closed. About 2% of tenured faculty are dismissed in a typical year, according to the National Education Assn.’s Higher Education Department.
That’s more job security than in most occupations, of course. Your spouse also may have access to a defined benefit pension, which would give him or her a guaranteed income stream in retirement. Those factors mean you reasonably can take more risk with your other investments.
As for your emergency fund, you may be fine with savings equal to three months of expenses. But consider that if your spouse were to be dismissed, he or she probably would have a tough time finding an equivalent position. If the institution starts having financial difficulties or if there is any reason to suspect that he or she could be dismissed, a fatter fund could come in handy.
Dear Liz: Over the last couple of years I have managed to pay off my credit cards. I know that closing those accounts will hurt my credit so I kept them open. When I checked my credit report, I found that my rating had gone down and was told that I had to actually use the credit cards and pay them off to keep my score up. I’ve been doing that over the last year or so and my credit score responded well. This past month my credit score went down again by a few points and I learned that it was because the credit card companies had rewarded my diligence by raising my credit limit. This apparently hurt my score. What’s up with this? Is there any way not to get dinged by the reporting agencies?
Answer: Higher credit limits would reduce the percentage of available credit you are using, and that should help your credit scores, rather than hurt them. So the score you’re seeing either isn’t a FICO score, which is the score used by most lenders, or you are being given questionable information about what affects your scores. Many score monitoring systems are set up to give you explanations for any change in your numbers, but those explanations might be vague or might not accurately depict what’s truly influencing your scores.
Your FICO credit scores change all the time, based on the ever-changing information in your credit reports. Variations of a few points shouldn’t be a cause of concern. Continue to use your cards lightly but regularly, paying the balances off in full each month. Over time, the variations will smooth out into higher scores.
Today’s 20-somethings have a unique–and easily blown–opportunity to set themselves up for their future. Because of the power of compounding, the money they save now for retirement is worth far more than if they start even a few years later. The idea that you can put it off and “catch up” when you’re older? Basically, it’s a myth, since it’s so very, very hard to make up for missing that early start.
NBC News columnist Bob Sullivan outlines how this works in “When $30k is worth more than $90k.”
The takeaway? Paying off debt is important, but not as important as saving for your future. Opportunities to save for retirement really are “use it or lose it,” and blowing them off could make your future self the real loser.
Please join us around 4:50 p.m. Eastern/1:50 p.m. Pacific for the discussion.