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Investor Profile: Balancing Retirement and Education Investments

Investors: Bill and Susan Baxter
Age: Both are 38
Occupations: Bill is a Manufacturing Quality Manager ($50,000); Susan is a Computer Programmer ($40,000)
Family status: Married, two children (10 and 6)

Sometimes it's hard to know when you stop being a young investor, and when it's time to begin to think more seriously about retirement.

That's the question facing the Baxter family. Neither of them has crossed the age-40 threshold, and their children are still young. Education and other major expenses for their children are much closer on the horizon than retirement. Nonetheless, Bill and Susan know that they can't put off their retirement planning.

All things considered, they've made a pretty good start. Both are investing for retirement out of each paycheck, thanks to the 401(k) programs that their employers offer. Susan contributes 6% of her income to her plan, the maximum amount that her employer will match. (She could contribute another 6% unmatched, but she chooses not to.) Although Bill's company doesn't match contributions at all, he likes the discipline and tax-deferral 401(k)s offer, so he contributes the full 10% of his income that the plan allows.

Playing catch-up

Although they're doing well now, the Baxters are making up for some lost time. Susan took a total of four years out of the work force when her children were very young; during that time, she couldn't make 401(k) contributions. IRA rules were different then, so she could only put $250 a year into a traditional IRA. However, in recent years, the rules have improved dramatically for spouses who don't work outside the home.

For his part, Bill has been making the maximum contribution to his company's 401(k) for almost the entire time he's worked there – just about six years. At his previous job, though, he only contributed 3% of his income (that employer matched half of his contributions). When Bill changed jobs shortly before the birth of his second child, he didn't roll his old 401(k) over into an IRA. Instead he took the money out, incurring tax and penalties that reduced his payout by about 40%.

While the Baxters are confident they're making a meaningful contribution toward their retirement, they have a nagging sense that they need to do more. They're also wondering how to make greater contributions in the next two decades, during which their children will grow up and attend college – and presumably need a little help with tuition.

They're glad they have the option of withdrawing IRA funds penalty-free for their children's college education. Also, Bill's company allows him to borrow funds from his 401(k) and pay the interest back, through payroll deduction, to his own account. But they will consider these only as a last resort. They don't want to slow the growth of their retirement nest egg if they don't have to.

Fortunately, there are many ways to help make the bite on their budget easier to take.

First, they should both very seriously consider opening Roth IRAs with the maximum $5,500 each. The earnings on Roth IRAs are tax-free when investors follow the rules for taking Roth distributions. Ideally, they would pay for both IRAs without reducing their 401(k) contributions. If that's not possible, though, it makes sense to take the money from Bill's current 401(k) contribution, because his employer doesn't match contributions. The Roth's potential for compounded tax-free growth over the 25 years until their planned retirement is more appealing to the couple than the benefits of tax deferral the 401(k) offers.

Next, they can consider bringing Susan's tax-deferred 401(k) contribution up to the maximum 12% (and restoring Bill's, if they cut it to pay for his Roth IRA). Even though they won't get an employer match on these additional contributions, when it comes to retirement planning it's important to make the most of all the tax benefits available. Because 401(k) contributions are made with pre-tax dollars, the difference in their paychecks will be significantly smaller than the additional investments they're making.

How do they get there from here?

Although the Baxters have a very comfortable income, it will still take some thought to rev up their retirement investments – particularly with the demands of raising a family. Here are a few points for them to keep in mind:

  • Stocks for long-term growth

    To get the greatest long-term growth potential, the Baxters will want to consider devoting a significant portion of their retirement assets to stocks. Because retirement is still well in their future, they may want to invest more aggressively. Many 401(k) investors choose conservative options that grow slowly – and sometimes don't keep up with inflation.
  • Education options abound

    When their children's college education gets closer, the Baxters may be tempted to take distributions from their IRAs to meet tuition costs. Although this option is helpful when other sources of money are exhausted, it's important to remember that low-cost loans are available to help pay for college – but not to help pay for retirement. Education Savings Accounts can be an excellent way to dedicate investments for children's education.
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