529 vs Roth IRA:  Which is Better for College Savings?

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We’ve all been conditioned to believe the well-known 529 plan is the “designated” college savings vehicle – people tend to think of it automatically when planning.

But should they?  Maybe… maybe not.

We all know what’s happened with college costs.  The government has thrown money (college loans, grants, etc.) at students and colleges, in an attempt to recruit, have put much of that money into student unions, high-end dorm rooms, and a lot of other bells and whistles driving the cost of college sky high.  I’m not sure if academic proficiency has kept pace with the improvement of infrastructure, but it has made saving for college more of a challenge for parents who are looking for new ways to save.

Families can seek student aid and file a Free Application for Federal Student Aid (FAFSA).  With more than 100 questions on the form – many are financial – it helps those friendly folks in Washington decide just how much a student should pay for their own education.  It’s calculated, in part, based on the assets of both the student and parents.   Yes, 529 plan assets are included in the calculation.

So, if you save through the “designated” vehicle expressly created for that purpose, it actually works against the student, reducing or even eliminating the amount of financial aid for which the student would otherwise qualify.

But wait!  (I love it when they say that in those infomercials)

There may be another way!

Yes, 529 plans allow some tax breaks as long as 529 plan money is used to pay for qualified higher education expenses, like tuition.  Those distribution are tax-free at the federal level and some states may even allow a state income tax deduction.

But what if things change?  What if the student decides to go to a trade school or do something else?  What if your child gets a full scholarship?   What happens then?  That money you’ve been saving in a 529 plan isn’t tax free anymore and may even be subject to a 10% penalty.

Not good.

So what’s another possible strategy?  The Roth IRA! What if the money had been saved in a Roth IRA?

The Roth also allows for tax-free distributions as long as the Roth IRA owner is over age 59-1/2 and they’ve had any Roth IRA for five years or longer.   People have been waiting longer to get married in recent years, making both thresholds easier to meet.  But even if the owner hasn’t reached age 59-1/2 or met the holding period requirement, Roth IRA contributions can be distributed at any age – at any time tax-free and penalty-free.  So, contributions over ten years, for example, can be withdrawn at any time for any reason, tax-free and penalty-free.

Oh yes, money converted to a Roth IRA from a traditional IRA might possibly also be distributed tax and penalty free, as long as the conversion took place five years ago, or longer.

How do Roth IRA distributions to pay for college impact the child’s chances for aid in future years?  It could.  It depends.  (consultants always like to say that.) 

The child or parent can take out loans for education expenses as needed, then use Roth IRA funds to pay off the debt.   Note:  The parents’ Roth IRA isn’t counted as an asset for FAFSA.  That’s good.  Distributions, however, are counted as income for FAFSA purposes, even if those distributions are tax free.  This means the parents are okay the first year they fill-out the FAFSA form, because there’s been no distribution to pay for college costs as yet.  If they do take a Roth IRA distribution to pay for college related expense, it might reduce or eliminate their eligibility in future years.

However, if they use student loans to pay for education expenses, they can wait until they no longer need to file a FAFSA form for aid and then use the Roth IRA to repay the loans.  By the way, interest paid on the student loans is a deductible expense. 

Taking out student loans and making timely repayments (even from funds taken from the Roth IRA) can be used to build credit… not just average credit, either, when the amounts can be many thousands of dollars.

Not bad.

Jim

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Jim Lorenzen, CFP®, AIF®

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-based registered investment advisor with clients located in New York, Florida, and California. He is also licensed for insurance as an independent agent under California license 0C00742.  IFG helps specializes in crafting wealth design strategies around life goals by using a proven planning process coupled with a cost-conscious objective and non-conflicted risk management philosophy.

Opinions expressed are those of the author.  The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-based registered investment advisor with clients located in New York, Florida, and California. He is also licensed for insurance as an independent agent under California license 0C00742.

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