While I am a huge fan of 529s and their ability to grow tax-free (tax-free distributions as long as they are for educational expenses), it is this exact rule that may end up hurting a family’s investment due to its rigidity.
For high income families, the 529 is great. If you are a middle class family and haven’t started contributing to your Roth IRA and maximizing your $5,500 contribution, there is value in doing that first before a 529. This is to kill two birds with one stone.
Let’s explore the scenario where the Unsure family (Ben and Maggie) have a newborn child, Peter, and are preparing for higher education savings for 18-20 years down the line. Many things could play out differently so let’s explore two scenarios where Ben and Maggie go with a 529 and in another scenario where she goes with a Roth IRA.
Let’s say, Ben and Maggie made contributions of $75,000 and their account grew to $150,000.
- The Unsures can use the entire $150,000 towards college and there will be no taxes due during distribution.
- The Unsures could have contributed $140,000 in one shot (a “hypercharged” contribution for 5 years), or $14,000 a year per parent. (Makes sense for high income families)
- Certain states have tax advantages like New York where a 10k tax deduction (for a couple) is given for 529 contributions. California does not have that advantage. There is no federal tax deduction for a 529.
- Overblown “disadvantage”: 529 is considered a parental asset. 5.64 percent of the 150k ($8,460) counts towards financial aid.
- During this time, the money was mainly invested in funds and the limited choices the state plan allowed.
The Roth IRA
- The Unsures had piece of mind throughout the years, knowing if this money didn’t go to Peter’s college, it goes to retirement.
- The Unsures were able to be more diversified in their investments. In reality, the $150,000 would probably have grown to more, if they were more bullish. A laddered bond maturity strategy could’ve also made money available right in time when Peter goes to college, mitigating risk.
- Only $5,500 (or $6,500 if you’re over 50) can be contributed.
- Only contributions (in this case, 75k) can be withdrawn tax-free and penalty-free. Anything in excess will be “gains” and those are also penalty-free, but NOT tax-free if withdrawn before the parent is 59.5 years old.
- Some parents may not be able to set up a Roth IRA due to high income limits. Your Modified Adjusted Gross Income (MAGI) must not exceed certain thresholds. For single parents in 2016, income above $118,000 is subject to phaseout (limiting your contributions), and above $133,000, you cannot set up a Roth. For two-parent homes, the thresholds are $186,000 and $196,000 respectively.
- When you take the distributions out from your Roth IRA to pay for college, it will be counted as student income on the following year’s FAFSA, thereby reducing what they could get in aid money. Click here to calculate how student income would affect financial aid. Solution: Don’t take distributions until you are no longer applying for financial aid.
Ben and Maggie made contributions of $75,000 and the account grew to $150,000, and only $75,000 is tax free for college in a Roth IRA.
18 years later, Peter needs all the funds to go to college
- WINNER: 529, hands down. With a Roth IRA, half of the 150k (the 75k of gains) is taxed.
18 years later, Peter needs some ($75,000), but not all, of the funds to go to college
- Only $75,000 is tax free for college in a Roth IRA. That’s just the right amount, so functionally this is like it would have been with a 529.
- The other $75,000 is retained for retirement. The retirement plan moves on without a hiccup.
- If the Unsures did a 529, and they have other children, they can roll the 75k excess to other beneficiaries.
- However, if they don’t, they would incur the 10% penalty when they withdraw the funds – which they should do ASAP, or future gains would keep staying in an unfavorable penalty-prone position.
- WINNER: Roth IRA
18 years later, Peter needs none of the funds to go to college (he got a scholarship or he doesn’t care to go to college)
- WINNER: Roth IRA, by a country mile.
- If the $150k doesn’t get used for educational expenses, the Unsures would take a huge hit and income that year. $7,500 (10% of the gains) would go to the penalty.
Therefore, it is something I say to all families: while an investment vehicle may seem attractive, like a 529, what are the practical realities? Do you need that flexibility, and are you saving up for retirement? I would think deeply about these 3 scenarios – no one can predict the future, but an educated guess can guide you in your decision making.
Marc Ang (Mangus) is a financial planner based in Claremont, CA, focused on spreading the gospel about responsible, educated and smart financial planning.