For clients that do not have assets to gift to a child or a business to employ a child in order to maximize a child’s tax capacity, they may have to use their retirement accounts to pay for college. Therefore, they should maximize their retirement accounts so that, if needed, they can be used to fund part of the college costs and maintain the desired retirement program.
Retirement Accounts Versus Taxable Accounts
While retirement accounts have the advantages of tax deferral and, in some cases, employer contributions, the income and capital gains generated will be taxed at ordinary tax rates when the funds are withdrawn. Therefore, the client must consider investing for college and retirement via non-retirement taxable accounts. If the client invests in low-dividend stocks and low-turnover mutual funds, the client will still get the advantage of tax deferral because little or no income is reported until the shares are sold. In addition, the gain on sale will be taxed at the lower capital gain tax rates and will not be subject to a 10% penalty if withdrawn before age 59½.
However, if retirement accounts are going to be used to save for college, the retirement account funds should be put into investments that produce income that is not eligible for the capital gain tax treatment. These investments would include high-turnover mutual funds, bonds, treasury bills, and high-dividend stocks. Nonetheless, the best retirement vehicle for these funds may be the Roth IRA. In this type of investment the income is never taxed if certain requirements are met. Contributions to Roth IRAs are nondeductible, but earnings will be tax-free. In addition, the original contributions may be withdrawn for college both tax- and penalty-free.
Retirement Account Rollover Versus Withdrawal
It is a common practice for clients to “rollover” the assets in their 401(k) retirement plan into an IRA upon leaving their employer. This enables the client to avoid being currently taxed on the retirement earnings and capital gains. However, if the retirement plan is heavily funded with shares of the employer’s highly appreciated stock, the client may consider an alternative to the rollover option. The client may want to consider paying the tax currently on the appreciated stock rather than rolling them into an IRA.
- A portion of the withdrawal will be taxed at capital gain rates.
- The withdrawal may qualify for the special “10-year averaging” tax treatment.
- The client can rollover part of the account into an IRA and keep the rest out of the IRA.
- A step-up basis at the time of death applies for any appreciation in the stock during the time the employee holds it.
- The withdrawal is currently taxed.
- The withdrawal may be subject to a 10% early withdrawal penalty. The penalty is based on the cost basis of the shares (to the extent this basis is currently taxable) rather than the fair market value of the stock.
- The basis of the stock does not receive a step-up in basis at death. Only the appreciation beyond the acquisition value receives a step-up in basis.
Withdrawal Of Retirement Funds To Pay For College
If retirement accounts are to be used to pay for college, the timing of the withdrawals of funds from these accounts must be considered. Other than IRA withdrawals that are used to pay for college, withdrawals from retirement accounts before age 59½ are subject to a 10% early withdrawal penalty. In addition, the withdrawals, except for withdrawals from non-deductible IRAs or Roth IRAs, are taxed at ordinary income tax rates. Therefore, the withdrawal of funds from these accounts should be delayed until after age 59½ to avoid the early withdrawal penalty. In addition, if the client’s income is expected to be lower during retirement years, delaying the withdrawals until retirement years will result in the withdrawals being taxed at lower income tax rates.
In order to avoid the harsh tax treatment of retirement account withdrawals before age 59½, the financial advisor should consider having the client obtain loans during college years and use retirement account withdrawals after age 59½ to help repay the loans.
Home equity loans and Federal PLUS loans are the preferred type of loans to be used by a client to pay for current college expenses. The tax deductibility of the interest, subject to certain limitations and the availability of extended repayment periods of up to 30 years, make these the loans of preference. The interest on these loans will reduce the client’s current tax liability while the funds in the client’s retirement accounts grow tax-deferred.
Age-weighted Or Permitted Disparity Retirement Plans
Age-weighted profit-sharing plans take into account both age and compensation when allocating contributions to the retirement plan participants. Participants earning more than a certain income level are allocated a greater percentage of the employer’s contribution than other lower-compensated employees. Permitted disparity plans are designed to provide highly-compensated employees with a greater benefit than non highly-compensated employees. Age-weighted plans, as well as permitted disparity plans, are really safe harbors for meeting the nondiscrimination requirements applied to all qualified retirement plans. A plan can be age-weighted and permitted disparity; however, the advantage is likely to be minimal.
- Maximizes the client’s retirement account.
- Minimizes the contribution to the client’s employees’ retirement accounts.
- Provides retirement/college funds for older or highly compensated employees in an economical way.
- The plan must cover all employees.
- The plan is subject to complex ERISA regulations.
Comparability plans may be a good way to save for college for business owners and principals who are older, on average, than their other employees, want the contribution flexibility of a profit sharing plan, and, want the largest possible share of the plan contribution allocated to their own accounts.
Non-qualified Deferred Compensation Plans
A non-qualified deferred compensation plan may be used to defer currently unneeded income until it is needed for college costs or retirement. These plans avoid most of the cost and administrative requirements associated with establishing a qualified plan under ERISA. Without having to comply with the anti-discrimination provisions of a qualified plan, the employer is able to pick and choose who will participate in the plan. Therefore, the employer, subject to the reasonable compensation limits, can provide an unlimited, substantial benefit to selected employees. The employer receives a tax deduction when the deferred compensation is actually paid to the employee. The employee reports the income at this point.
These plans usually take one of two forms: salary continuation or salary reduction. A salary continuation plan is an agreement where the employer promises to pay future compensation at retirement without deferral of the executive’s current compensation. The plan provides benefits in addition to the executive’s salary and does not require a reduction in the executive’s present salary.
In a salary reduction arrangement, the executive defers receipt of compensation from the current year to his or her retirement. This usually involves an elective deferral of a specified amount of the compensation the executive could take but chooses to defer. Many executives select this as a way to save more aggressively for retirement than otherwise possible.
In choosing an informal funding vehicle, the business owner must consider that a product that generates taxable interest, dividends, or capital gains creates an additional asset for the corporation to track (not to mention current corporate tax liability).
Under current law, the life insurance contract is one of the few financial vehicles that have tax-deferred growth, and the corporation can use the income tax-free death benefit to help corporate cash flow and cost recovery objectives. Because of these advantages, many arrangements specifically are designed to use life insurance.
If a client does not feel that enough funds will be accumulated for college and retirement needs at the projected retirement age, the client should consider delaying retirement to a later date. By delaying retirement the client will continue to have employment earnings, employment fringe benefits, and retirement contributions, possibly matched by the employer. Since withdrawal from retirement plans would be delayed, the assets in these accounts will continue to grow on a tax-deferred basis. To insure that enough funds have been set aside for college and retirement, the client should consider not allocating resources to other segments of the overall financial plan. For example, gifting to family members may have to be minimized or travel and vacation costs may have to be cut.