As the cost of college education becomes ever-increasing, the concern for parents who wish to help fund their children's higher education costs becomes more prevalent. People often ask us what the 'best' way is to save for their children's future college expenses. The most common answer is to begin funding a 529 plan. A 529 plan is an account specifically designed for education planning and saving. Any qualified education expenses can be covered from the account tax-free. This can be a powerful tool for education planning, but is it appropriate for everyone? This post will show an example of someone we met with where an alternative approach to a 529 plan made more sense in her situation.
In our initial meeting, her son was in 8th grade and she wanted to begin saving for his college expenses. Her goal was not to pay for all of his educational expenses, but rather a portion of it in order for him to minimize or avoid a large student loan debt upon graduation. She had been told a 529 plan was often the best way to save for college. We discussed how a 529 plan is designed for education planning and saving. We also pointed out that if the 529 account is not used for educational expenses, the distributions will be taxed as ordinary income. She wanted some potential flexibility with college savings in case her son decided not to attend college, so we gave her an alternative to consider; a Roth IRA.
Utilizing a Roth IRA to help fund education planning is a tool some people do not consider when evaluating their education funding options. It works similarly to the 529 plan in that it grows tax-deferred and contributions are after-tax. Since Roth contributions are made after-tax, they are allowed to be withdrawn tax-free at any time for any reason, including for college expenses. The growth in a Roth IRA can be withdrawn tax-free after age 59 1/2 since it is meant to be a retirement saving vehicle so depending on the parent's age, that portion of the account may not be available to fund college expenses. It is noteworthy that establishing and contributing to a Roth IRA will not count against the child's FAFSA and financial aid for school. In comparison, a 529 plan with the parent as the owner of the account would count against the child's FAFSA and financial aid.
After comparing the two options, she decided a Roth IRA made more sense to her specific situation. She would not be 59 1/2 during the time her son is in college, but will still be able to access the contributions to help his college funding. Her plan after his college expenses are taken care of is to use the growth in the account for when she is retired as an extra layer for emergency reserves and any larger lump sum purchases. Instead of using a 529 plan for education planning, she took a "hybrid" approach by using a Roth IRA for education planning and retirement planning.
~John and Courtney