Investing for a child's education

College tuition and associated education costs rise annually. If you have young children, the price you'll pay for their education could be significantly higher than today's prices. Despite this cost escalation, you'll want your children to have the option to go to the college of their choice. So how do you save enough money for college and still achieve your other goals?

Understand your options

Educational costs are a significant budget item for any family, but you do have a number of options. You can start early by budgeting education funding for your children from birth. You can also help them save for their own higher education expenses during their pre-college years. Children generally have access to loan programs and other tuition-assistance programs.

Explore investment programs for your child

You have a variety of options available to help save for your child's education. To fully explore all of your choices, we recommend consulting a financial professional.

With a Coverdell Education Savings Account (formerly Education IRA), you may make nondeductible contributions of up to $2,000 annually to one of these accounts for each child until age 18, assuming you meet the program's income limits. Consult your financial professional for income limit and other qualifying information. Earnings accumulate tax-deferred and distributions for qualified expenses are tax-free.

The Qualified Savings Tuition Plan, Section 529, is another option that allows after-tax investment. Many states allow contributions in excess of $300,000 per beneficiary. Withdrawals are federally tax free if used for qualifying higher education expenses. Non-qualified withdrawals are subject to federal and state income tax and a 10% penalty. The money in this program is held in the donor's name, usually the parents or grandparents, and can be transferred to another child or returned to the donor if the child elects to skip college.

By investing in a 529 plan outside your state of residence, you may lose any state tax benefits. Also, 529 plans are subject to enrollment, maintenance, administration/management fees and expenses.

Help your children help themselves

If your children are still young, they can contribute to their own higher education savings with after-school jobs, paper routes, or other activities. You may want to establish an investment account and teach your children to routinely contribute some of their earnings. You'll not only be reducing your future educational costs, but you'll be teaching your children a valuable savings habit.

While investing in your child's name offers some advantages, there are other considerations you'll want to weigh. When your child reaches college age, 20% of his or her money will be considered available for college expenses, while only about 5% of your assets (excluding retirement accounts) are counted when qualifying for education assistance programs. Investing in your children's names could impact their ability to qualify for assistance. Also, children aren't required to spend their invested money on college tuition. They could buy a new sports car or take an extended trip to Europe.

Maintain your own retirement savings

In an effort to provide for their children's education at all costs, some parents neglect their own retirement savings. If your budget doesn't allow you to save simultaneously for your child's education and your retirement, many professionals recommend that you forego the education savings. Children have various options for paying for their education, including student loans and other assistance programs, and they have a working lifetime to repay those debts and move ahead.

If your retirement planning comes up short, however, you may find yourself financially dependent on your children. Maintaining your own financial strength is key to the success of both your children's future and your own. If you must, you can withdraw your retirement funds to help pay for your child's education. Federal law now allows you to do so without incurring the usual 10% early-withdrawal penalty, but you'll still pay income tax on the portion of the distribution that would otherwise have been subject to income tax. Generally speaking, withdrawing money from your retirement plan should be considered a last resort because it could jeopardize your future financial security.

Changing jobs

Whether you're been laid off or you're moving to a better opportunity, or even scaling back on work, career changes are a big event. Before you fully focus on your future, however, don't forget an important financial decision—how to handle the money you've accumulated in your current employer's retirement account. The decisions you make about this retirement money could affect your future financial security.

Understanding your options

Ask your employer about your existing retirement plan. Your options will vary depending on the type of plan and your length of employment. Generally, you'll have three basic choices for 401(k) plans or other similar plans - reinvesting, transferring, or cashing out. If you've been laid off, you may have an additional choice - maintaining assets in your employer's plan. You'll probably want to carefully explore your options and consult with a professional before making any decisions. And, you'll want to avoid triggering unnecessary tax liabilities.

Maintain assets at your employer

If you've been laid off, talk to your employer to determine if you may be able to leave your savings in your existing plan. Your assets remain in a qualified tax-deferred or tax-free account. You won't be able to make subsequent contributions but you'll still have control over how your money is allocated among the plan's investment options.

Reinvesting

You can keep your retirement savings on track by reinvesting the money in another tax-deferred retirement savings program such as a rollover IRA. If you roll your money over correctly, you'll avoid taxes and penalties. First, don't procrastinate. You must roll over your money within 60 days of the date your distribution was issued. If you wait, the money will be considered ordinary income, and you'll owe taxes and possibly a penalty. You'll also want the distribution check made out to the new plan administrator or IRA trustee. If the check is made out to you, 20% must be automatically withheld for federal income taxes.

A Roth IRA is another option. Roth IRAs accept only after-tax contributions, so you'll create a taxable transaction if you roll your retirement money into one of these accounts. However, the money will grow tax deferred and, if you've had the account for at least five years, all withdrawals after age 59½ are tax-free.

Transferring

You'll need to check with your new employer to see if your new plan offers a transfer option. If it does, you can open a conduit IRA, which is a temporary account in which your money can be invested until you can transfer it into your new plan.

Cashing out

Just taking the cash and spending it is a costly choice with a potentially significant long-term impact on your financial future.

If you cash out, you'll owe federal taxes at your ordinary income rate and a 10% penalty if you are under age 59½. Depending on where you live, you may also owe state and local taxes. This means you could lose nearly half of the money in your account to taxes and penalties.

You'll also forfeit the long-term benefits associated with tax-deferred compounding. If left to grow over a long period, even a few thousand dollars can grow to a sizeable amount. A $10,000 investment, for example, could grow to more than $55,000 at a 6% return over a 30-year period. *

Think carefully before you decide to cash out your retirement account. Your future financial security may depend on that money.

Watching your pre- and after-tax money mix

If your current employer's plan allowed you to make both pre- and after-tax contributions, you'll need to track these funds separately and check with a professional about the details for rolling over these funds. You won't want to pay taxes twice on the same money.

*This hypothetical example is for illustration only and is not intended to reflect the return of any actual investment. Investments do not typically grow at an even rate of return and may experience negative growth.