WHICH IS MORE IMPORTANT; CONTRIBUTING TO A COLLEGE FUND OR 401-K?
By MARY LYNNE DAHL, CFP®
February 14, 2020
(SitNews) Ketchikan, Alaska - David and Jean Smith are typical working people. They are married with 2 kids. David is 35 and Jean is 34. She recently returned to work now that their youngest child has started first grade. They are seeking some answers to their questions that they now have as a result of Jean returning to paid work.
They are meeting with their newly hired financial advisor, who is a certified financial planner with experience in personal financial planning and retirement planning. Their primary questions revolve around the issues of choosing to contribute, from Jean’s salary, to her 401-K plan at her new job or contributing to the college fund they have set up for their kids.
But first, the background details are important to consider. There gross annual income has gone from David’s earnings of $55,000 per year to $90,000 per year with the addition of Jean’s salary of $35,000 per year. Their monthly household expenses are approximately $4,000 per month. They currently have $5,000 n emergency savings at the credit union where they bank.
They plan to pay down the principal of their mortgage with part of their increased income and pay off some credit cards that they have not been able to pay off monthly. They are unsure of how long it will take to pay off the credit cards entirely. They also do not know how many years sooner their mortgage will pay off if they pay extra on the principal. Their main question, initially, is what to do with the $500 per month that they have calculated they will have as extra from Jean’s wages, after taxes, payroll deductions, and her efforts to pay down their debts.
After gathering enough data to get a solid picture of their total financial situation, the Smith’s and their financial planner lay out a cash flow plan, based on their budgeted income and expenses. Next, their financial planner examines their tax returns for the last several years to determine their tax bracket and to spot any tax issues that may cause problems later. She does not find any tax issues that would cause problems, and she does determine their tax bracket, based on the exemptions, standard or itemized deduction, child care credit and any other tax details.
Next they jointly go over the credit card debt and the mortgage. Their financial planner runs calculations on the mortgage to determine that the extra payments on the principal, if continued, will pay off their 30 year mortgage 9 years early. The credit cards are a bit trickier to figure out, but overall, if they want to pay these off entirely, it will take them about 2.3 years of dedicated effort and payments of about $300 per month, of which Jean will pay $150 and David will pay $150. David will also pay the extra on the mortgage principal.
They will pay off the highest interest rate card first, then the next highest, and finally the lowest interest rate card last. They could also roll all of the debt into the lowest rate card and reduce their out-of-pocket max payments by about $50 per month, which they are likely to decide to do. On the advice of their financial planner, they will have this discussion at home and let her know their decision.
Upon examination of the 401-K plan document Jean was given at work, it is clear that she will not be eligible to begin participating in the plan for about 6 months. So, during that time, their financial planner suggests that she bank the $500 per month into their savings account, which is now just $5,000. Their planner recommends that be increased to $12,000, and notes that the $500 per month in added savings will bring it up to $11,000 in just 6 months, during the time Jean is waiting to begin participating in the 401-K plan at work.
Then, after a discussion of priorities and cash flow, their financial planner lays out a 5 year plan for them. In it, she recommends that for the first 2 years, they pay off credit card debt, build their emergency savings to $12,000 and start participating in the 401-K plan at $500 per month. Jean will qualify for the employer match with this contribution, giving her even more incentive to contribute the full $500 per month, or $250 per pay period (26 pay periods).
But, you say, what about contributions to the college fund for those 2 kids? Isn’t that just as important? Well, yes, it is important, but more important than retirement? No, it is not more important than retirement, not even just as important. It is less important, and here is why: these kids might get a scholarship, or contributions towards college from other family members like grandparents who can afford it, or they may work during college, or get some military benefits, or all of these things. And guess what? Once the Smiths pay off their credit card debt, they will, indeed have extra money to put towards college. In addition, an annual contribution of $6,000 into Jean’s 401-K plan will reduce their income taxes by about $1,320. This is money that they will not pay in taxes, so instead they can contribute it the college fund. In Alaska, they can also contribute their children’s permanent fund dividend to that same college fund. Over time, these amounts will add up and be significant when the kids are ready for college or technical school.
This plan will accomplish a lot more than just the initial concerns that David and Jean Smith had when they sought assistance with their cash flow concerns. They now have a 6 year plan, are committed to getting out of debt and have a strategy to do it, plus they have funded both Jean’s 401-K and their kids’ college fund. They are on their way to financial security, have learned some great techniques for managing their money and are increasingly becoming more financially literate. In the next few years, they will meet once or twice per year with their financial planner to be sure they are on track, and in 5 years they will sit down with her and develop a plan for the next 5-10 years. Job well done!
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