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401(k) or 529: Which is better for college savings?

July 24, 2012: 5:50 PM ET

I've been looking for the right kind of investment tool for college savings. My son is eight years old, and my husband is 56. Does it make sense to consider college savings plans, such as a 529 plan, when we have old 401(k) plans we could withdraw from after we reach 59 ½? ― Nancy C.

Yes, it makes sense to consider college savings plans rather than planning to withdraw from your 401(k)s. It's true that you can make penalty-free withdrawals from 401(k) plans after age 59 ½ — but that's an expensive way to fund college.

Distributions from your 401(k) are counted as taxable income, points out Tim Gormley, a certified financial planner and vice president of investments at the Gormley Furlong Group of Stifel Nicolaus in Yardley, Penn. "You'd get hit by higher taxes while paying tuition. That's a double-whammy," he says. The distribution could also affect your son's eligibility for need-based financial aid the following year. By comparison, distributions from 529 plans generally are not taxable if used toward education expenses, and they don't affect federal financial aid eligibility (though many colleges do include 529 plans in their financial aid calculations).

Accessing retirement funds, even "old" ones, should be done only as a last resort, says Judy Sciaky, a certified college planning specialist. She says that removing the money from your plan sacrifices the potential for decades of tax-deferred growth. Instead, she says, continue to set aside money in your 401(k)s, and then save any additional money in a 529 plan or other college savings vehicle.

— Marc Mewshaw

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