If you have noticed a bit of moroseness in your children in recent weeks, it’s likely because they are well aware that summer vacation will soon be coming to an end. Of course, that also means the kids will be one year closer to graduation, which, given the skyrocketing costs of college tuition, should make you quite morose as well. Although the thought of an empty nest may fill you with many mixed emotions, an empty bank account is an unmitigated misfortune.
A “New” College Savings Option
Typically, most people who are looking to save for college first turn to a state-managed 529 plan, and given their many benefits, it is easy to see why. Most notably, many states allow you to deduct contributions into your 529 plan from your income taxes. In addition, they have large contribution limits — up to $28,000 per year for a married couple before gift taxes becomes a consideration.
However, a somewhat creative alternative to the 529 plan has gained popularity in recent years as a possible vehicle for college savings: the Roth IRA. At first blush, this may seem strange. Roth IRAs are supposed to be for retirement, not college. Otherwise, there would be no need for the “R” in IRA. That being said, names can often be deceiving: Greenland is covered in ice, jellyfish aren’t fish, and peanuts aren’t actually nuts.
Likewise, Roth IRAs can be turned into a de facto college savings account. But why would you want to do this? The main reason is that Roth IRAs give you a degree of flexibility that is unmatched by any other tax-advantaged account, including 529 plans. As usual, your Roth IRA contributions (not earnings) can be taken out at any time and can be used for any purpose. Meanwhile, 529 plans are designed specifically for education expenses. If used for any other reason, you will be subject to potential taxes and penalties.
Roth IRA vs. 529
In addition, the earnings from a Roth IRA that has existed for at least five years can be taken out without the typical 10% penalty if used for qualifying educational expenses. Although, you will be subject to ordinary income taxes unless that money is withdrawn after the age of 59.5. When you combine this with the fact that Roth IRAs tend to give you more investment options and lower fees than a typical 529 plan, the choice between the two no longer seems so obvious.
However, before you eschew 529 plans entirely, you should also consider the downsides of using Roth IRAs for educational expenses. Most notably, money taken out of a Roth IRA for college expenses cannot benefit from continued tax-free compounding for your eventual retirement. In addition, contribution limits are lower for Roth IRAs, and you can also forget about the deduction on your state income taxes. Finally, using a Roth IRA in lieu of a 529 plan could adversely affect your child’s financial aid because Roth IRA withdraws are considered as part of your income.
As a general rule, assuming that the money is actually used for education expenses, 529 plans are usually your best choice. Of course, if you can contribute to both, that is even better. Although Roth IRAs are best used for retirement, they can still give you an extra source of available money if your other assets are ultimately not sufficient to cover all the costs of college.
For more information or to set up a consultation, contact Pathway Financial Planning at 248-567-2160 or email firstname.lastname@example.org.