Beach House or College?
As college costs continue to rise, knowing how and where to save is a decision many families struggle to make. It is never too early or too late to start saving and knowing which education savings options are available can have a significant impact.
Should we buy a beach house in Florida and retire early or send the kids to college? While that may seem dramatic, the costs of raising a child and sending them off to college help put the numbers into perspective. It is no secret that college tuition is rising faster than just about everything except for healthcare these days. Add on top of that the estimated $230,000 it costs to raise a child from birth to age 18 and that beach house begins to look even more appealing.1
Couples today are more inclined than ever before to save money for their children’s future education, due in large part to the rising costs. Unfortunately, it is not always clear which savings vehicle is the best for their hard-earned money. Additionally, prioritizing retirement savings versus education savings is a choice many families are struggling to make. There are a variety of ways to save for each, and even an option that helps accomplish both goals, but our focus is on two of the most popular and effective savings plans: the 529 Plan and Roth IRA's.
What is a 529 Plan?
A 529 plan is an account created specifically for saving for college and other qualified college-related expenses, as determined by the IRS. The accounts are set up and managed by each individual state, but you do not have to be a resident of the state plan in which you choose to invest. It is also important to note that these accounts can be used for vocational and technical schools as well.
With a 529 Plan, anyone can contribute to the child's account up to a maximum of $15,000 per year, without any income limitations. These funds can then be invested in a mix of options that typically include the following:
- Static or Target Allocations where an investor chooses a model portfolio ranging from conservative to aggressive, and the portfolio adheres to this goal throughout the life of the account, regardless of the beneficiary’s age.
- An Age-based option which allows the investor to choose a model portfolio based on the child's age, usually consisting of conservative, moderate, and aggressive options. These portfolios will automatically shift over time to become more conservative as the child nears college age.
- Individual fund selection gives the investor the ability to customize the portfolio by choosing from a mix of underlying mutual funds. The investor controls which mutual funds to hold in the account and how much to allocate to each mutual fund. The account will continue to hold these investments until the investor decides to make a change.
How can a 529 plan be used for education?
Because 529 Plans are designed specifically for education expenses, the IRS allows money to be withdrawn from these accounts tax-free as long as the money is used for qualified expenses. Such expenses include tuition, fees, books, computers, and room and board. And although contributions are not deductible on your federal taxes, they may be deductible on your state tax return. Many states only offer a tax deduction for contributions made to their own 529 plan. However, there are six states (Arizona, Kansas, Minnesota, Missouri, Montana, and Pennsylvania) that allow taxpayers to deduct contributions made to any 529 plan.
It is also important to note that the Tax Cuts and Jobs Act of 2017 (TCJA) introduced two new changes affecting 529 plans that could have far-reaching impacts. The first change allows 529 plans to be used to pay up to a total of $10,000 of tuition per beneficiary each year at an elementary or secondary public, private, or religious school, including homeschool.2 The second change made under the TCJA allows funds to be rolled over from a 529 plan to an Achieving a Better Life Experience (ABLE) plan. ABLE accounts are tax-advantaged savings accounts for individuals who become mentally or physically disabled before age 26, and they are designed to enable those with disabilities and their families to save and pay for disability-related expenses.3
At this point, you may be wondering what to do with the money you have saved in a 529 Plan if there's any left over after your child has finished school, or if they chose not to attend college at all. In this case, the beneficiary of the account can be changed from one child to another, or even to another family member, without any tax consequences. You can also change the beneficiary to yourself so you can finally take that French literature course you have always dreamed about. Lastly, if none of those are viable options, you can withdraw the money for other uses, but these would be considered non-qualified distributions which have adverse tax consequences.
What is a Roth IRA?
A Roth IRA is an Individual Retirement Account to which you contribute after-tax dollars. Although you do not get to deduct your contribution on your tax return, the money you set aside in a Roth IRA grows tax-free and can be withdrawn tax-free in retirement. For 2020 the maximum you can contribute to a Roth IRA is $6,000, plus an additional $1,000 if you are age 50 or older. A Roth IRA may not come to mind when thinking about saving for college, but it is certainly an option worth considering. While the Roth IRA is typically dedicated towards retirement savings, it does offer a few unique advantages over 529 plans:
- Your contributions to a Roth IRA are available to you at any time, tax and penalty-free. Additionally, any distribution of earnings from your Roth IRA that is used for qualified education expenses is exempt from the 10% early withdrawal penalty, although they would still be subject to ordinary income taxes.4 If you are over 59 ½ years old and have owned the account for at least five years then any distribution is tax and penalty free, regardless of the amount or purpose.
- Unlike a 529 plan, investment options are almost unlimited in a Roth IRA. The account owner is not forced to pick from a pre-selected list of options or model portfolios and over time the ability to select your own investments can result in better performance.
- And finally, the decision about what to do with money leftover in a Roth IRA after college expenses are paid is much easier to make.
How can a Roth IRA be used for education?
Even though Roth IRA’s were designed for an individual’s retirement contributions, using the account for education expenses may make sense for many families. With the median household income being just under $62,000 nationally in 2018,5 many families find it difficult to save for both retirement and education and prioritizing one over the other is a choice most would prefer not to make. In such a scenario, making maximum annual contributions to a Roth IRA could help a family achieve both goals.
Of course, this is not the only scenario where the Roth IRA may be the best choice. For many people, the flexibility of the Roth IRA makes it a more appealing option than the 529 plan. It is not always clear that a child will attend college and if they do, how much it will cost. The Roth IRA allows an individual to navigate around those issues by providing for retirement income if the account is not used for education expenses.
Potential Roth IRA limitation
When comparing a Roth IRA versus a 529 plan one final consideration must be given to the account owner’s income. For those filing a joint tax return, your ability to contribute to a Roth IRA in 2020 begins to phase-out at $196,000 of Adjusted Gross Income and is eliminated at $206,000. Single filers are subject to phase out limitations starting at $124,000 and ending at $139,000. Taxpayers with income above these limits may find it difficult, if not near impossible, to contribute to a Roth IRA. Of course, there are always exceptions to the rule so it is best to consult with your tax or financial advisor to see what options may be available to you.
Ultimately, the best course of action for each client should be determined through careful thought and a discussion with their financial advisor so that a fully informed decision can be made. In an ideal scenario both a 529 and a Roth IRA would be opened and funded, but we certainly understand that it is not always feasible. It is imperative to remember that no matter what type of account is opened or strategy is implemented, the decision should align with each client’s goals and objectives and be suitable for them and their family.
2IRS offers guidance on recent 529 education savings plan changes
4Can a Roth IRA be used to pay for college?
5U.S. Median Household Income Up in 2018 From 2017
Author: Ian Cerminara, CFP® | Associate Financial Advisor | Allegheny Financial Group | May 2020
Allegheny Financial Group is a Registered Investment Advisor. Securities offered through Allegheny Investments, LTD, a registered Broker/Dealer. Member FINRA/SIPC.
