Category: Education

Recently I saw a recommendation that you should put your college savings into a Roth IRA instead of a College 529 plan because the Roth savings would not be included in parental assets for assessing whether your child would be eligible for financial aid. This, however, is not as straight forward as it might seem. There are trade offs that mean the real answer is it depends, and in these cases, I like to do the math.

First the rules. With both a 529 plan and a Roth IRA, your investment earnings grow tax-free while in the account. With the 529 plan, withdrawals for qualified educational expenses are tax-free as well. With the Roth, you can withdraw contributions tax-free, but the earnings will be taxed at your regular income tax rate. Roth withdrawals for educational purposes do not incur the 10 percent penalty for early withdrawal.

The 529 plans in thirty seven states allow you to deduct your contributions from your state income taxes up to a limit. In Oregon, for example, you can deduct $2,435 if you are single and $4,865 if you are married. However, you are limited to the investment options available in your state’s plan. If you don’t like those, or your state does not offer a 529, you can save for college in any other state’s plan, but you won’t get the tax deduction. Earnings still grow tax-free and are not taxed on withdrawal for education.

The argument in favor of using a Roth IRA is that retirement savings are not counted in your assets on the Free Application for Federal Student Aid (FAFSA). Therefore, in theory, your child would be eligible for more financial aid if you saved in a Roth instead of a 529 plan. However, the earnings on your savings will be taxed and you won’t get the state tax deduction for your contributions (if it’s available to you), so you will have less total savings available for college given the same annual savings amount.

Now for the math. Given the tax implications of saving in a Roth, are you really better off than if you saved in a 529 plan? The answer depends on how much savings you have outside of retirement plans. Your expected family contribution (EFC) based on your savings alone (there is also an income test) will be 5.64% of your family assets per year. Your home, retirement savings and an allowance for emergency savings are excluded from the calculation. The allowance for emergency savings is based on the average cost of living for a family of your size. It usually ranges between $25,000 and $35,000.

The following table shows how the two options compare when your child is about to enter college, assuming you save $2,400 per year from the time your child is born until they are eighteen. It also assumes you have $100,000 in savings outside retirement plans at that time. I’ve assumed federal and state taxes combined are 30 percent, and that 529 contributions get a state tax deduction of 9 percent, based on Oregon’s tax rate. College savings also earn 4 percent per year in investment returns.

In this example, for the same annual savings rate, you would be better off saving for college in the 529 plan. Between the tax exempt withdrawal and the tax deduction for contributions, which I’ve added to college savings, you would have nearly $6,500 more available for college (the difference between the additional college savings and the additional financial aid) than if you saved in a Roth IRA. The 529 advantage declines with more in taxable savings. Given my assumptions, the break even level of taxable savings is $215,000.

There is one other reason you might consider using a Roth IRA as a college savings vehicle. If your child does not go to college, the Roth IRA can stay invested, and you can use it for your own retirement, with withdrawals being completely tax-free after age 59 1/2. With the 529 option, if the funds are not used for education purposes, the earnings will be taxed at your income tax rate plus a 10 percent penalty. However, you can transfer the savings to another child, or use them for your own continued education tax-free. A variety of vocational classes as well as college classes are eligible educational expenses.

If the funds are not used for education, you will have $2,200 more savings in your Roth IRA, than if you withdrew the 529 plan money and paid the taxes when your child is eighteen. The Roth would continue to grow tax-free until retirement. Alternatively, your 529 plan money could stay in taxable savings for retirement. In twenty years, the IRA option would have $6,500 more in it if your investments earned an average annual return of 7 percent and your tax rate remained at 30 percent.

As you can see, it’s not a straight forward answer of one or the other. If your child does go to college, the 529 plan offers serious tax benefits, especially if you live in a state that offers a tax deduction for 529 contributions. But if you have substantial taxable savings, or you ultimately don’t have any educational expenses, the Roth IRA could be a better option.

You certainly cannot know what the future holds for your child, so there is no wrong answer here. The important piece of the equation is that you are saving for her education in the first place. Whether you save in a 529 plan or an IRA is a secondary consideration. So save away, and don’t worry too much about whether you have the right type of account.

For a comprehensive, step-by-step guide to building your own financial plan, pick up my book, Save Yourself; Your Guide to Saving for Retirement and Building Financial Security. It is now available on Amazon.

Recently a friend asked me about a strategy proposed to her by a financial adviser. The adviser was recommending that she and her husband invest their children’s college savings in a life insurance policy. Here were the benefits as given by the adviser:

• The money grows risk free.
• It is life insurance the children can keep for the rest of their lives.
• The money isn’t counted as family assets for financial aid purposes.

On the surface these seem like good ideas. Saving for college in a life insurance policy has been a strategy promoted for ages. In fact, Gerber Life has promoted these policies on national TV for years. However, life insurance is probably the least effective way to save for college there is. If someone recommends a life insurance policy for your college savings, run.

The policies promoted are known as permanent or whole life policies. As long as you pay the premium you will have life insurance for as long as you live and a guaranteed death benefit when you die. A portion of your premium pays for the death benefit and a portion earns interest which builds up a cash value. Over many years, the cash value grows, and it and the death benefit become one and the same.

The money does grow risk free at a low interest rate. The cash value will not decline, unless you withdraw it or stop paying the premiums, and it will grow slowly over time. However, there are many college savings options that offer a  greater return and much lower expenses. The death benefit is a big expense that cuts into your college savings, as does the hefty commission the adviser earns for selling you the policy.

Many state 529 plans offer age based investment options that gear their investment strategy to the remaining time until your child starts college. Though not guaranteed, these options offer sound strategies that can more efficiently grow your college savings.

As a permanent life insurance policy, your children can keep the policy at the same premium rate for their lifetimes. However, to withdraw the cash value to pay for college, they will either need to take a withdrawal, which is a taxable event, or borrow from the policy. Any amount you withdraw or borrow reduces the death benefit, and withdrawals can be subject to a fee called a surrender charge.

Children don’t need life insurance. You only need life insurance if there is someone depending on your income, and that is not the case for anyone until they have a spouse or children of their own. Your children can buy their own, much cheaper, term life policy when they get married.

Life insurance is not included in family assets for purposes of determining eligibility for financial aid, whereas money saved in a 529, or other college savings plan is. However, the first $20,000 in savings is exempt from the Expected Family Contribution (EFC) and the EFC is capped at 5.64 percent of parental assets. You can save quite a bit before your child’s eligibility for financial aid is impacted.

When your children are young, it is important for you to have life insurance on yourself. You’ll want your children to have all the advantages you would have provided if something happens to you. However your children don’t need their own life insurance, and it is an expensive and inefficient way to save for college. If you have money to put toward your children’s education, check out your state’s 529 college savings plan instead.

Photo by Colin Maynard on Unsplash

The holidays are upon us. I’ve always thought Christmas was mostly about the kids. There is nothing better than seeing a little face light up at the decorations or the absolute glee in your child when she receives that one thing she wanted most of all. But all the gifts can get out of hand.

With grandparents and aunts and uncles all giving to your children, your kids could be on overload before breakfast Christmas morning. If your kids’ eyes are glazed over before they’re done opening all their presents, consider a different tactic that can cut down on the volume of gifts and help with your children’s future. Ask your relatives to make a contribution to a College 529 plan instead of buying the usual gifts that may be forgotten in a corner before long.

A College 529 plan is a tax advantaged savings program for post high school educational expenses. Investment earnings grow tax free and withdrawals for educational purposes are tax exempt.

An AARP survey found that 36 percent of grandparents believe it is their job to spoil their grandchildren by buying them lots of stuff, mostly at the holidays. Of grandparents surveyed, 25 percent will spend more than $1,000 in a year on their grandchildren, and 40 percent will spend more than $500.

Those amounts can add up to substantial college savings by the time your children are ready for school. If your children were to receive a total of $500 in gifts each holiday season from their relatives beginning when they are babies, a 529 plan could grow to well over $14,000 by the time they are 18, assuming a 5.0 percent annual return. Smaller amounts also help. Some 529 plans accept deposits on existing accounts as low as $15.

The gift giver benefits as well. Contributions to a 529 plan in 34 states are state tax deductible, and in two thirds of those states, you don’t need to be the owner of the account to get the deduction. In Oregon, for example, a single person can deduct up to $2,300 of their contribution, and a married couple can deduct up to $4,600. If a larger gift is made, the extra over the deductible limit can be deducted in future years.

For the states where you do need to be the owner to get a deduction, the gifter would open their own account and simply name the child as the beneficiary. There is no limit to the number of accounts that can be opened for a single beneficiary.

For the 16 states that don’t offer a 529 plan, an account can be opened in any other state’s plan. While contributions are not deductible, the investment earnings will still grow tax free. There is no obligation to attend school in the state where the account is opened. Savings in 529 plans can be used for educational expenses at a wide variety of schools nationwide.

There are no limits to annual contributions for 529 plans. Gifts greater than $14,000, which is the gift tax exclusion amount, require the filing of a gift tax return. However that does not mean the gift will be taxable. It can remain tax exempt under the lifetime exclusion for estate taxes, currently at $5.49 million per individual for federal tax purposes. The maximum lifetime 529 plan contribution limit is $300,000

If your child doesn’t attend school, the money can continue to grow tax free in case they change their mind later. The money can remain in the plan as long as there is a living beneficiary, and you can change the beneficiary if school isn’t in the cards for the first one.

If the money is not used for educational purposes, you will pay income tax and a 10 percent penalty on the earnings. While that sounds terrible, if you’ve had the money invested for a while, chances are your earnings will have grown, and you will still come out ahead.

Instead of your parents buying gifts that won’t last or will be set aside to gather dust, have them invest in your child’s future. Toys wear out. Clothes are outgrown. Electronics become obsolete in no time. Most kids can only take so much unwrapping on Christmas. A College 529 plan contribution is a gift that will have a lasting impact, and have your child remembering Grandma and Grandpa’s gift all their life.

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There seems to be a lot of confusion regarding 529 plans, the program for college savings. As a result many families don’t take advantage of them. Yet 529 plans are a great way to save for college. They are widely available, provide tax advantages and are more flexible than you may think.

There are 108 unique 529 plans available across the country. At the end of 2016, there was more than $275 billion invested in them. Yet many families aren’t taking advantage of the benefits this savings option offers. Only about 2.5 percent of families owned 529 accounts at the end of 2013, according to the Federal Reserve.

A 529 plan is a tax advantaged way to save for college. Regardless of whether your state offers one, you can save for college in a 529 plan, and all the earnings on your investments accumulate tax free. Qualified distributions are also tax free. The tax savings on the earnings alone are worth a lot.

Suppose you save $100 per month starting when your child is born until she goes off to college. If your account earns 6.0 percent per year and your combined state and federal income tax rate is 35.0 percent, saving in a 529 plan will allow it to grow by an extra $7,400 relative to a regular taxable savings account earning the same. If your state does offer a plan, they also may offer tax incentives to contribute to it. Contributions may qualify to be deducted from your income for state tax purposes, making saving for college a little easier.

Anyone can invest in any state’s 529 college savings plan. You can find an annual ranking of 529 plans online from Morningstar. SavingforCollege.com also offers a ranking, though they use different criteria. If your state offers a plan, the tax benefits on the contributions may make it worthwhile to invest in your own state’s plan, even if it isn’t top rated.

Worried that the money saved in a 529 plan is only eligible to be used at the public universities in your state? While there are plans that allow you to save specifically for your state’s schools, called prepaid tuition plans, there are only 20 of them across the country.

The vast majority of plans will allow you to withdraw the money tax free to pay for expenses at virtually all accredited public, nonprofit, and for profit post secondary institutions any where in the country. It doesn’t matter if the school is a college, university or vocational school. Here in Oregon, 529 plan savings from any plan can be used for everything from the University of Oregon and Oregon State to Le Cordon Bleu College of Culinary Arts and a wide variety of programs in between.

What if your child doesn’t wind up going beyond their high school education? First you never know what your child will do in the future. There are no limits to how long money can stay in a 529 plan, as long as the beneficiary is living. If your child doesn’t go to school right away, they may down the line. If that doesn’t happen, the beneficiary of the account can be changed to anyone in your family out to first cousins of the original beneficiary. That means the money could be used for your own education, your siblings or their children’s education. Even your parent’s can use it if they have a desire to go back to school.

If there is absolutely no one in the family that can take advantage of the money, it is still yours. It can be withdrawn at any time. Withdrawals that are not made for qualified educational expenses will be taxed with an additional ten percent penalty. This is what get’s people concerned about saving in a 529 plan. But it’s not as bad as it sounds.

In the example above, total earnings on the account are $15,500. This is the amount on which the taxes owed will be calculated. Assuming the same 35.0 percent combined tax rate, the taxes due would be $5,425 plus an additional penalty of $1,550, or total taxes of $6,975. You would also have to repay any state tax benefits you received on the contributions.

This is not the end of the world. You get all of your contributions back, and the taxes you wind up paying are still less than the additional benefit you gained by growing your savings tax free ($7,400). Paying back the state tax deductions on the contributions will cost a bit more, but you will still have more money than you contributed to the plan in the end.

529 plans are a great way to save for college. If you have doubts, make sure you get the facts before you give up on this tax advantaged savings option. For more information regarding 529 plans, check out the SavingforCollege.com web site, or visit the site for your own state’s plan. 529 college savings plans can help you make more out of your college savings dollars, and they are more flexible than you may think.

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