College is expensive and that’s not changing anytime soon. In fact, it will likely continue to rise in cost. That’s why saving for your child’s education right now is more important than ever.
Many parents consider starting a 529 plan. Known as a qualified tuition plan, a 529 plan allows you to save money for your child’s college education that grows tax-free. While plans differ from state to state, the opportunity to let your money compound tax-free is certainly attractive.
But beware, there may be times when a 529 plan isn’t the best option, especially if it’s the only way you’re thinking of funding your child’s education.
The reason?
What’s Ahead:
A 529 plan could mean less financial aid.
The largest drawback to a 529 plan is that colleges consider it when deciding on financial aid. This means your child could receive less financial aid than you might otherwise need.
While there are a few ways around this, such as having a grandparent hold the plan, ultimately you may want to think of other options, especially if you don’t believe the 529 plan alone will cover the cost of a college education.
Consider a Roth IRA instead
Not all saving plans are considered in financial aid. The Roth IRA is just one of them.
Roth IRAs are more flexible than 529 plans, and while they don’t receive the same tax deductions, they can be used for education and retirement alike.
Another reason you may choose an IRA over a 529 plan (or in addition to) is that you can withdraw money from a Roth IRA–penalty free–to pay for education.
If you withdraw money from a 529 account and use it for something other than its intended purpose, you’ll pay regular tax as well as a 10% penalty tax on the earnings. This is especially important if your children decides to pursue a career that doesn’t involve a college degree.
Finally, a Roth IRA is definitely a better idea for the eight states that don’t receive tax breaks on 529 plans. These states include: California, Tennessee, Kentucky, North Carolina, Delaware, New Jersey, New Hampshire, and Maine,
Compromise: Start a 529 plan when you’ve maxed out your retirement fund
529 plans certainly have their strong points and most people should start them, but they work best in conjecture with a retirement account such as a Roth IRA.
With Roth IRAs, there are limits to how much you contribute in a year—$5,500 to be exact. 529 plans aren’t as constrained. You can contribute up to $300,000 dollars overall, since this is likely the cost of a qualified education. But again, if you’ve contributed this much or even a fraction of this, and your child decides they don’t want to attend college, there are serious penalties for using this money for anything other than educational purposes.
That’s why it’s best to start with a Roth IRA and, if you max that out each year, you can start contributing to a 529 plan.
Even more options in addition to a 529 plan
There’s nothing inherently wrong with 529 plans as long as you use them for qualifying educational expenses. But there are other means to save for college.
A few other options besides the Roth IRA mentioned above are CDs, brokerage accounts, and alternative savings accounts.
CDs
Certificates of deposits are no longer the most popular way to save for college or other major financial matters. But, paired with other means of saving, they’re still a strong choice.
There are some CDs (known as EE Bonds) that qualify for tax exemptions if used for educational expenses.
Combine these with a Roth IRA or 529 plan and you should be able to get your child through college.
Brokerage accounts
Typically, people save for college over a number of years. So investing the money somewhere it’ll grow is important. Brokerage accounts, much like savings accounts where you can deposit or withdraw money at any time, are good options for a number of reasons.
You can open a brokerage account through a broker (although some say brokerage fees aren’t worth it), and they’ll know where best to invest your money.
The downside is that there are no tax advantages with a brokerage account, like there are with 529 plans. And you’ll be responsible for the taxes on the gains your money earns.
Coverdell Education Savings Accounts
These accounts are similar to 529 plans, but are reserved for those with a low income. ESAs can also be used for k-12 expenses as well as college.
The one drawback is the contribution limit: just $2,000 a year. Even if you saved for 18 years, that would only fund a year at some state universities.
Summary
529 Plans are great savings vehicles for college, after all, that’s what they were created for, but there may be better options. A Roth IRA provides more flexibility, but with stricter contribution limits. It’s important to weight the pros and cons of each before deciding. Or start both in order to cover all your child’s education expenses.
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Article comments
I think you missed an important opportunity here to say that parents should first fund their own retirement and only then consider saving for their children’s education. If the Roth IRA is in your name it should be considered as a vehicle for your retirement. If you have a surplus of funds stashed elsewhere, like a 401k, I can maybe see the logic, but I doubt that’s the case for most people. If a child has an earned income and has contributed to a Roth IRA I could see that being a solution (they’ll have time to rebuild), but otherwise this seems like you’re robbing Peter to pay Paul. Please don’t forget that a child can go to community college or take out loans, but you cannot take out loans for retirement.
The 2020 Roth IRA contribution limit is $6000, not the $5,500 as indicated in the article.
There are limitations to withdrawals from a Roth.
– Principal on a Roth IRA must be held for at least 5 years in order to be taken out tax free even for school or to buy a house.
– Even after 5 years, only the principal can be taken out tax free. Earnings taken out are subject to income tax.
– only If the account holder is aged 59.5 or older, the withdrawal of both earnings and principal are entirely tax free.
And finally money taken out from retirement accounts will count as income the following school year which could impact your financial aid negatively. It could be overcome if using these funds the final year of college since since they won’t be in school the following year.
I also agree with Christine’s comment. What about the parent’s retirement account. Not everyone has a 401k so to use a Roth as a college savings vehicle is not the best strategy. The Roth should be use for a parent’s retirement.
I’m pretty sure the article is saying to set up a Custodial Roth IRA in the child’s name, not to use the parent’s Roth IRA. As a parent you can match a child’s contribution (up to 3,000). So if you have a teen that works and makes at least 3k, they can put that in the Roth and the parent can match it to max out their yearly 6k contribution. If you have the money there is no reason NOT to do both a Roth AND a 529 after maxing out the Roth.
The only hitch comes with taking the money out of the Roth, which should be done in the LAST year (to pay off student loans or whatnot) so that it doesn’t get counted as income for financial aid.
Not sure you caught an important consideration in the article you linked. Only 5.26% of a 529 account held in parent’s name counts in the FAFSA calculation, and none of the withdrawals count as income for the student in subsequent years. If anyone else holds the 529 on behalf of the student (including grandparents), the assets don’t count toward FAFSA calculations, but the withdrawls count as INCOME for the student in the following year, and count as 50% in FAFSA calulations. So if you get $5k from grandma’s 529, that’s $2500 less you can receive in aid.