Retirement planning

Here’s how families can utilize both to save for college using a 529 plan and a Roth IRA.

Nobody needs to be an academic to recognize that attending college is expensive and only going to get more so. According to the Education Data Initiative, college tuition in the United States climbed by around 4.6 percent yearly between 2010 and 2020, exceeding inflation as a whole. Even though public institutions are often less expensive, their costs have increased dramatically as well, increasing by around 2.8 percent yearly during the same time span.

If you have to pay for it, you’ll want to make the most of your savings by using all of your options. You should consider the 529 savings plan, which was designed to help with college expenses, before utilizing a regular taxable account or having to take out a student loan. Due of the numerous tax benefits of a Roth IRA, you could also think about using one.

Here are the benefits and drawbacks of paying for education with a Roth IRA or a 529 plan.

What are 529 plans and how do they operate?

A tax-advantaged savings plan sponsored by states, governmental agencies, or educational institutions is known as a 529 plan, sometimes known as a qualifying tuition plan.

It is available in two variations:

  • Plans with prepaid tuition, whereby the saver acquires credits at participating universities for later use. Typically, accommodations are not included in plans.
  • Plans for saving money for education, in which the saver registers an investment account to pay for eligible college costs like tuition and room and board.

As long as the withdrawals are used for approved school costs, the contributions to a 529 plan can grow tax-deferred and any withdrawals are not subject to federal income tax (and frequently, state taxes, as well). A 529 plan can be utilized for both K–12 and post–secondary education. Additionally, it can be used to trade and vocational schools.

Because contributions are made after taxes, savers do not immediately receive a tax benefit from the federal government for doing so. Many states do, however, provide tax credits or deductions for charitable contributions.

Additionally, 529 plan contribution limitations may be higher than IRA contribution restrictions. Despite the fact that each state’s plan may have a different maximum contribution, you may be subject to gift taxes if you give more than the $16,000 for 2022 or $17,000 for 2023 gift tax exemption. The Roth IRA, on the other hand, allows you to set aside $6,000 (for 2022) or $6,500 (for 2023) while those over 50 can save an additional $1,000 year.

The 529 plan can be a helpful tool for extended family members to contribute to college costs. According to Philip D’Unger, a certified financial advisor at CAPTRUST, “Anyone can contribute to a 529 plan — this is an opportunity for relatives to aid with funding.” Additionally, “these funds can be transferred to a 529 plan for the benefit of other family members” if they are overfunded.

529 programs’ benefits and drawbacks

A 529 plan has numerous benefits, but it might not be appropriate for everyone or in every circumstance.

Education tax savings are significant with 529 plans, according to Joshua C. Young, a wealth advisor at BakerAvenue Wealth Management in Sun Valley, Idaho. “529 savings accounts are an incredible tool that provides savers with a combination of state income tax deductions, tax-deferred savings, and tax-free distributions for qualified educational expenses,” he says.

The primary benefits of these plans are those mentioned above, but 529 plans also have an edge over Roth IRAs, particularly for parents who are still relatively young.

Younger parents may benefit more from 529 accounts.

According to Jim Mahaney, principal at Mavericus Retirement Services in Montclair, New Jersey, “earnings cannot be withdrawn from a Roth IRA prior to age 5912 without paying taxes, so parents who will be under that age when their child is in college will likely be better off investing in a 529 plan.”

Morris Armstrong, the founder of the tax preparation company Morris Armstrong EA, points out that this warning only applies to the earnings in a Roth IRA, not the contributions. If you are younger, your contributions will be tax-free and your basis will be deducted first.

529 plans can be a little bit rigid.

The rigidity of 529 plans is arguably their biggest drawback. The plans can be used for education, but that is essentially all they can be used for, at least without consequences. But as a result of recent amendments, beneficiaries are now able to use a 529 plan to pay off up to $10,000 worth of student loans for each of their siblings and themselves.

You might have to withdraw the funds if you are unable to use them for allowable costs. If so, you will be subject to income taxation on the earnings (but not the principal you contributed), and any earnings you withdraw will be subject to an additional 10% penalty.

However, there are other methods to spend the money that won’t result in taxes or penalties, like changing the beneficiary to a sister or other family member, funding your own continuing education, or putting the money aside for a grandchild.

A 529 plan’s investment possibilities are constrained.

Additionally, education savings programs could only offer a predetermined selection of investments, making it impossible for you to invest in precisely what you want. Usually, you can choose from a variety of fund portfolios, but some of the choices might not be ideal for you.

How does a Roth IRA operate and what is it?

A Roth IRA is a kind of IRA that enables you to accumulate funds in a tax-advantaged account and then withdraw them tax-free after you reach retirement age, which is generally regarded as age 5912. Thus, savers make contributions today after taxes in order to benefit from a tax cut tomorrow. (This is in contrast to a standard IRA, which now receives the tax advantage.) The maximum annual contribution to a Roth IRA is $6,500 in 2023 and $6,000 in 2022, with a $1,000 catch-up contribution allowed for people over 50.

Due to the flexibility with which the saver can take money out, the Roth is particularly adaptable.

Money deposited to a Roth IRA can be withdrawn tax- and penalty-free by a person under the age of 5912, provided it is spent for higher education costs and the account has been open for at least five years.

However, withdrawals of both contributions and earnings are tax- and penalty-free for everyone beyond the age of 5912.”

Roth IRAs’ benefits and drawbacks

Although Roth IRAs have many benefits for investors, it’s crucial to keep in mind that they are only appropriate for use in retirement.

Roth IRAs come with a lot of tax advantages.

According to Matt Boelter, senior director of financial planning at Edelman Financial Engines, “Roth IRA accounts have the same taxation benefits as a 529 account.” The additional advantage is that they are not restricted to paying for school.

The most flexible investing vehicle is a Roth IRA.

The Roth IRA also has advantages over 529s in terms of investing opportunities, where investors are restricted to funds that might not have low-cost alternatives. With a Roth, which lets you invest in almost anything that trades on a public market, that is not the case.

According to Armstrong, “with a Roth, you may either strike it rich with Apple or Netflix, or slog along with a portfolio of cheap index funds that captures the market.” “With a Roth account, you have a lot more control.”

A Roth IRA gives family members freedom to help a student.

According to Boelter, grandparents frequently use a Roth IRA to fund their grandchildren’s schooling. In order to reduce the tax hit of the conversion, he observes elderly investors moving a portion of their traditional IRA holdings to a Roth IRA over a period of years.

According to Boelter, there are multiple advantages to this strategy: “It decreases their future required minimum distributions from the regular IRA, gives the grandmother more control over the money, and the money is not deducted from financial aid.”

Roth IRAs can make it harder to get financial aid.

However, it’s crucial to comprehend how financial aid is impacted by the Roth IRA.

Roth IRAs are not listed as an asset on the Free Application for Federal Student Aid form, according to Mahaney. This is important for families applying for financial aid using the federal system.

However, if distributions are made from a Roth IRA, it may have an impact on a student’s ability to get financial aid.

According to D’Unger, income has a bigger influence on the FAFSA computation than savings do. Even though they are not taxable, Roth IRA withdrawals would be considered income on the FAFSA form, which would have a substantial influence on future eligibility.

To sum up

Even if you can use the Roth IRA to pay for educational expenses, it’s vital to keep in mind that the 529 plan and the Roth IRA were designed for particular use cases. Each account is thus best fitted to fulfill its specified function.

The best advantage for college savings will come through 529 plans, according to D’Unger. The Roth IRA, on the other hand, “is often advantageous for school savings when the saver is unsure of the intended use of the funds or needs to save for various goals in one account,” according to research.

Therefore, the flexibility of the Roth IRA may make it a superior backup account, although the 529 plan is a superior primary account.

According to Young of BakerAvenue, “We do not advocate that our customers use a Roth to cover their educational costs until they have exhausted all other possibilities, such as a 529 account or non-retirement assets.”

Young continues, “It’s crucial to keep in mind that a Roth IRA’s biggest asset is its long-term capacity for tax-free compound growth. Early asset depletion may impair the retirement security of some families and eliminate a crucial tool for wealth transfer for others whose financial planning objectives span multiple generations.

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