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When Saving for College, Don’t Overlook Roths

Aug 15, 2018 4 min read Ilana Polyak

Key Takeaways

  • A 529 bonus: gains grow tax-free as long as returns help fund your child’s education.
  • A Roth IRA offers something 529s can’t — options.
  • First comes retirement savings then comes your kid’s college plan.

 

Say the words “college savings,” and it’s pretty certain the account that will come to mind is the 529. These tax-advantage plans have become the way the majority of Americans save and pay for college.

 

 

But the 529 plan, while powerful, may not be the only resource in the college savings toolbox. Roth IRAs, while primarily retirement savings accounts, can also be used for college funding. They can additionally offer flexibility that 529s can’t.

Both have pros and cons. Below is a rundown of some important facts to consider

 

529s: When you want to save a lot

It’s not hard to see why the 529 is such a popular college savings vehicle. At the end of 2017, there was $319.1 billion invested in these college savings plans, spread out among 12.9 million accounts, according to the College Savings Plan Network and the Investment Company Institute.

Here’s how they work: Each state runs a college savings 529 program with several investment options. You can invest in a plan in any state, either directly or through a financial professional. Your state may offer an income tax deduction for contributions.

In addition, funds in 529 plans grow tax-free and are not ever taxed as long as the money is used to pay qualified college expenses Opens in new window.

But Amy Crow and Rich Deely, of Claremont, California, weren’t thinking about those benefits when they opened 529 plans for their children, David, 10, and Sadie, 6, shortly after their births.

“Taxes were not a consideration,” explains Crow, a librarian. “We just wanted a way to save for college.”

As the accounts grow, Crow and Deely, a museum educator, believe they’ll be able to pay a big chunk of their children’s college education—but not all, especially if they choose pricey private schools. “It really depends on where they eventually choose to go and the amount of financial assistance available to them,” Crow says.
 
529s make it possible to sock away significant sums. However, like any money you give away, you need to be aware of the gift tax. Anyone can gift up to $15,000 a year to any person without paying this tax. Amounts over $15,000 are subject to the tax, no matter where the money is going. For a couple, this means $30,000 can be gifted tax-free.

It’s not only parents who can contribute; 529s are also a good vehicle for grandparents, aunts and uncles to help with college expenses.

Crow and Deely are making use of this feature. “Amy’s parents are contributing,” says Deely.

 

But there are downsides

As good as 529s are, they have their limitations. Because funds can only be used to pay for qualified higher education expenses, there is a 10% penalty for making withdrawals for other purposes. In addition, income taxes are owed on any gains when the funds are not used for education expenses.

“But what if your kid doesn’t use the whole amount?” says Mark Struthers, certified financial planner and founder of Sona Financial in Chanhassen, Minnesota.

Perhaps your child will choose to skip college, or they may win a large scholarship. In that case, you can use the funds to pay for college for a sibling or even to further your own education. Even then, there might still be money left over, and you’ll have to incur the penalty and taxes if you want access to it.

And that’s not all. 529 plans can be counted as assets and may reduce your child’s need-based financial aid award. However, this will generally only be by 5.64% of assets, and qualified distributions by parent- or child-owned accounts do not count as income, and will not reduce the following year’s aid eligibility.

 

Roth IRAs can pull double duty

Many families feel that they’ve financially strained as it is, and it’s a struggle to save for both retirement and college simultaneously. Financial planners say you should consider emphasizing your own retirement first because, as a retiree, you have way fewer options to make ends meet than a college student does.

 

A Roth IRA can give you the flexibility to stress your own retirement and possibly pay for your children’s college if there’s enough to go around.

 

“When you are planning for college and retirement, you should put retirement first,” says Struthers. “But that doesn’t mean you can’t do both.”

A Roth IRA can give you the flexibility to stress your own retirement and possibly pay for your children’s college if there’s enough to go around. “It’s a dual-purpose account,” says Struthers.

Unlike traditional IRAs, contributions to Roths are made after taxes. You do not receive a deduction upfront. In exchange, the money grows tax-free and you can make tax-free withdrawals at retirement.

You are allowed to take withdrawals from Roths starting at age 59 ½, tax- and penalty-free (as long as you’ve owned the Roth for at least five tax years). If you are under 59 ½, you can take out your contributions with no penalty. What’s more, retirement accounts are not included as assets when applying for financial aid.

You also may have more investment options within Roth IRAs.

There are downsides to using a Roth too, however. For one, when compared to 529s, allowed contribution amounts are pretty small, just $5,500 a year if you are under 50 and $6,500 if you are older. And no contributions from other family members are allowed.

But the biggest downside is that withdrawals from Roths are considered income during the years you’re applying for financial aid. So if you withdraw $20,000 in your child’s freshman year, you’ll have to add that amount to your adjusted gross income that year. When you apply for aid in subsequent years, your income will therefore be higher, which could reduce your child’s reward.

 

What you can do next

While 529s are specifically designed for college expenses, you might have more flexibility using a Roth IRA. When thinking about how to pay for both, consider all the tools at your disposal. Talk to your financial professional about your personal circumstances and if you have specific questions about both options.

 

Ilana Polyak is a freelance writer who specializes in personal finance and the financial advisory industry. Her work has appeared in The New York Times, Barron's, Kiplinger's Personal Finance, Bloomberg BusinessWeek and CNBC.com.

 

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