With so many ways to pursue a higher education or increased expertise in a trade, craft, or industry, more and more parents are asking what the best way is to save for future education costs. My answer is often a combination of things. If I were forced to narrow it down, my two favorite ways to save for education expenses are 529 college savings plans and Roth IRAs. Here is a way to think about each and how to use them to best serve your personal education planning needs:
529 Plan
What is it? A 529 plan is a tax-advantaged way of saving for higher education expenses. These plans grow tax-deferred, and withdrawals are tax-free if used for qualified education expenses.
If you take a non-qualified distribution, the earnings will be taxed as ordinary income and may be subject to a 10% penalty. The 10% penalty is waived when the beneficiary receives a scholarship, veterans’ educational assistance, employer-provided educational assistance, the American Opportunity Tax Credit, the Lifetime Learning Tax Credit, and other forms of educational assistance. 529 plans also waive the tax penalty upon the death or total and permanent disability of the beneficiary.
Contributions: There is no earned income limit for 529 contributions. Individuals can contribute up to $15,000 per year or $30,000 for a couple making a joint contribution without incurring gift taxes or using the lifetime gift tax exclusion. 529 plans also provide an opportunity to front load 5 years of gift tax exclusions as a lump sum contribution ($75,000 for single, $150,000 for a joint contribution). There is an aggregate (lifetime) contribution limit that varies from state to state but typically ranges from ~$235,000 to over $500,000.
Any friends and family can contribute to a student’s 529 plan, regardless of who the account owner is. (On a personal note, I try to always include a link to my children’s 529 plan site whenever someone asks what to get my son or daughter for Christmas or their birthday. I can only hope that they will thank me later!)
Investment options: Typically, there is a limited and set menu of passively and actively managed funds. These include age-based options that reduce exposure to higher risk investments like equities as the student approaches college.
Taxes: Over 30 states offer a state tax deduction for 529 plan contributions, typically to their own state plan(s).
FAFSA (Free Application for Federal Student Aid) impact:
· 529 plans owned by a dependent student or the dependent student’s parent (custodial parent if the parents are divorced or separated) are reported as a parental asset on the FAFSA.
· Parental assets reduce eligibility for need-based financial aid by a maximum of 5.64% of the asset value.
· 529 plans owned by anybody else (grandparent, relative, friends etc.) are not reported as an asset on the FAFSA. However, distributions will be counted as untaxed income to the beneficiary on the FAFSA.
· Untaxed income on the FAFSA reduces aid eligibility by as much as fifty percent of the distribution amount.
Roth IRA
What is it? Roth IRAs are individual retirement accounts funded with after-tax contributions. They offer tax-free growth and tax-free withdrawals as long you’ve owned your account for 5 years and are age 59 ½ or older.
Roth IRA contributions can be taken out at any time without additional taxes or penalties. If you take any growth or interest out before you meet both the 5 year and age 59 ½ rules, then you may be subject to ordinary income tax and a 10% penalty. The 10% penalty of the Roth IRA is waived if the distribution was made to pay for higher education expenses, up to $10k for a first-time home purchase, or after the death or total and permanent disability of the owner.
Contributions: The annual contribution limit on a Roth IRA is $6,000 ($7,000 if age 50+) or your earned income, whichever is less. There are no aggregate contribution limits on a Roth IRA. Contributions are phased out for incomes of $125,000 to $140,00 for single filing or $198,000 to $208,000 for married filing jointly in 2021. Third parties cannot contribute to a taxpayer’s Roth IRA. However, the student can receive gifts, which the student can then use to contribute to their Roth IRA up to their earned income.
Investments: Typically, there’s a wide variety of investment options like a brokerage account which can include stocks, bond, mutual funds, exchange traded funds, and other investment options.
Taxes: Account holders can take a tax and penalty-free return of contributions at any time. Non-qualified distributions are subject to income tax and a 10% penalty except for distributions due to qualified education expenses, death, disability, or up to $10 for a qualified first-time home purchase.
FAFSA impact:
· The Roth IRA is not reported as an asset on the FAFSA.
· Qualified distributions from a Roth IRA and tax-free return of contributions from a Roth IRA count as untaxed income to the beneficiary on a subsequent year’s FAFSA and can reduce aid eligibility by up to 50% of the distribution amount.
· Non-qualified distributions count as part of adjusted gross income.
Strategies:
· If the student plans to graduate in 4 years, distributions that occur on or after January 1 of their sophomore year in college will not affect eligibility for need =based financial aid. (The FAFSA uses two-year-old income and tax information to determine eligibility.)
· If the student is on a 5-year track, then distributions would have to occur on or after January 1 of their junior year to have no impact on aid eligibility.
· Consider waiting until after the student graduates from college to take a tax-free return of contributions from the Roth IRA to pay down student loans.
· Use up to $10,000 of their 529 plan to pay down student loans after graduation
The Verdict:
The 529 may be the winner if:
· You value tax-free earnings for qualified education expenses.
· Your state offers a tax break, that tax deduction represents savings that can be allocated towards other goals or to further your education savings goals. You can use a site like savingforcollege.com to compare plans.
· You don’t want to get penalized by financial aid formulas for distributions since 529 plans receive more favorable FAFSA treatment as a parental asset
· You’ve started saving late and want to play catch up, then the 529 plan will allow you to contribute the most. (Roth IRAs are limited to $6k per year or $7k if 50 or older).
· You want your other kids, relatives or even yourself to have access to education savings, the 529 plan will allow you to change beneficiaries easily and can even be used for K-12 education expenses.
The Roth IRA may be the winner if:
· You are unsure your student will attend college or will need the money for college, and you value the flexibility of giving the student a head start on retirement savings or in the parent’s case additional funds for their own retirement.
· You plan on maximizing need-based aid since you can leverage little to no 529 savings while leaving the Roth IRA funds as a back up to pay down balances after their sophomore (4 year track) or junior year (5 year track).
· You value the flexibility and investment options of a Roth account and are unsure about the costs of college or how much you will or can contribute.
Your next steps:
· Run an education savings calculator like this one.
· Determine how much of that education you can afford to save for after prioritizing your own retirement.
· Determine which accounts to save and invest in that fit into your current planning and higher education assumptions.
· Make savings (for education or otherwise) a priority to your future students and consider adding it to the gift wish list on birthdays, holidays, or whenever they have extra money to save!
· Consider leveraging both the Roth IRA and 529 plans to provide flexibility in your education savings while providing potentially more savings for an increasingly expensive retirement for you and/or your children.