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.