529 beats Roth IRA for college savings

By: Savingforcollege.com

Q:

Dear Joe, Can my son use a Roth IRA -- rather than a cost-laden 529 -- to fund his 9-month-old daughter's future education? -- Jim

A:

Dear Jim,
To contribute to a Roth IRA, you must have earned income more than or equal to the amount of the contribution. Dividends and interest income don't count as earned income. Many children do have jobs and can start a Roth IRA, but I've never heard of a 9-month-old joining the workforce -- except, perhaps, for those actors in baby commercials.

Even if a child does qualify for a Roth IRA, I think it makes for a much better retirement vehicle than it does a college-savings vehicle. Earnings on a Roth can be distributed tax-free after the account owner reaches age 59½ and satisfies a five-year requirement. But earnings that come out before age 59½ are taxable even when used for college expenses. (The 10-percent early distribution penalty may be waived under the special exception for higher-education expenses.)

Of course, one nice part about a Roth IRA is that your contributions come out before the earnings do. In addition, the contributions portion can be used for any purpose, including education, without tax or penalty.

The surprise for many parents, however, is the potential financial-aid penalty: The entire IRA distribution, taxable or not, must be included in base-year income on the student's federal financial-aid application for the following year. This can dramatically reduce a need-based aid package.

In my opinion, your son should take another look at a 529 plan for his daughter. Contrary to popular belief, 529s are not necessarily laden with a lot of costs. In fact, the expenses associated with 529 plans have dropped significantly over the past few years.

Savingforcollege.com, recently published its annual 529 fee study comparing costs between all of the "direct-sold" 529 plans.

The study underscores how low costs are for many 529 plans. For example, in the Ohio CollegeAdvantage 529 plan, a $10,000 investment in the least-expensive equity investment option will cost only $293 over 10 years. That figure includes the expenses of the underlying Vanguard mutual funds.

With a 529 plan, the distributions used to pay qualified higher education expenses are tax-free regardless of your age, and they are not included in base-year income for federal financial-aid purposes.

Popular Questions

Question

Two kids, two 529 plans?

Dear Big Bill,
While it's possible to maintain a 529 plan in just one child's name, even when you intend to send more than one child to college, I generally recommend that families open a separate 529 account for each child.

That's assuming there is no additional cost to maintaining multiple accounts. If your 529 plan charges an annual or quarterly account maintenance fee, check to see if you can avoid the fee by signing up for automatic contributions through payroll deduction or electronic funds transfer)

With a separate 529 plan for each child, it becomes easier for you to tailor the mix of stocks, bonds and stable-principal investments (e.g., stable value, guaranteed principal and money market funds) to the particular ages of your children. When your older child is nearing high school graduation, you may want to ratchet down the level of market risk in her 529 plan. At the same time, you could keep a more-aggressive asset allocation in your younger child's 529 plan, accepting more risk for a potentially higher return. Many 529 plans offer "age-based" investment options that automatically make these adjustments as the beneficiary ages.

Separate accounts for your children also offer more gift-tax leeway. Since your 529 contributions are treated as gifts from you to the account beneficiary, your $15,000 (in 2018) annual gift exclusion will go twice as far with two accounts -- one for each child -- than with just one account.

Financial aid is another reason to recommend maintaining separate accounts. You wouldn't want the investments reserved for your younger child's future college expenses to count against your older child's financial aid eligibility. Be warned: The rules here are rather murky, and the impact of a sibling's 529 account may depend on the college's own policies as well on as the type of aid -- federal or institutional -- being sought.

Finally, I believe that separate 529 accounts allow for better family bookkeeping. There will never be any doubt as to your intention to help send all of your children to college. You'll avoid the uncomfortable position of being asked to explain to a curious 8th-grader why account statements are showing up in the mail with only a brother or sister's name on them. And in the event of your death or divorce, no matter how unlikely, your legal representatives and other family members will have less reason to question your actions in setting up and funding the 529 plans.

Even with separate accounts, you'll continue to have the flexibility to shift the money around in the future. You simply need to make sure that whenever funds are withdrawn from the 529 plan to pay for college they are coming from an account in the name of the child incurring the costs. It's a simple matter to change the beneficiary designation among family members at any time, transfer 529 funds between different family members' accounts or split one 529 account into two. The ability to move assets around the family is a key advantage of 529 plans when comparing other college-savings alternatives, such as Uniform Transfers to Minors Act, or UTMA, accounts.

Original Post: 2005-10-13
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Coverdell ESA vs. 529 Plan: Which to choose? (Script)

The Coverdell ESA and the 529 plan are both excellent college savings vehicles because they are both tax-free when used for college. But many families face a choice: do they use a 529 plan for all of their child's college savings, or do they use a Coverdell for the maximum amount of $2,000 each year and put any any extra savings above $2,000 into a 529 plan? In spite of its low annual contribution cap, Coverdell's are now attracting quite a few families. There are two major reasons for that. One is that only the Coverdell allows you to self-direct your investments, just like you might self-direct the investments in your IRA. The other is that in addition to college expenses, Coverdells can be withdrawn tax-free to pay for a broad range of K-12 expenses, while 529 plans are limited to K-12 tuition. This feature is appreciated most in families planning to send their children to private grade schools, which may include additional costs such as room and board or uniforms. A 529 plan, on the other hand, does not impose age limits or income limits like the Coverdell does and so overall we see a lot more money going into 529 plans than into Coverdells. Plus many savers are happy with the investment choices offered by the 529 plans and don't necessarily want to self-direct their investments. And don’t forget this: your state may be giving you a state tax deduction for using a 529 plan, but there are no states offering a state tax deduction for investing with a Coverdell ESA.

Learn more about Coverdell ESAs.

Original post date 2013-07-15
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Top 529 Plan Withdrawal Tips. (Script)

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Top 529 Plan Withdrawal Tips. (Video)

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