A Good Way to Save For Education Costs

 

For some time now the cost of a college degree has been rising at a shocking rate, and as a result the dream of one day going to college, for many, remains just that…a dream. But the rising cost of college has brought heavy debt burdens that have many new graduates wondering if they will be able to pay off their loans before they retire. The challenge for parents can be trying to save for their own retirement while saving for their children’s education at the same time can seem just as daunting. Many parents and students have traditionally looked toward loans as a solution to cover these climbing costs. While student loans seemed manageable decades ago, today’s graduates are emerging from college owing tens of thousands of dollars. Americans have amassed a record-high $1.2 trillion in student loan debt, with the average college graduate emerging with approximately $30,000 in student debt (Institute for College Access and Success – 2014). People are looking for new and creative ways to save for these expenses.

 

529 plans

There are traditional ways such as such as 529 plans and Coverdell education savings accounts. A 529 plan, legally known as a “qualified tuition plan,” can be sponsored by states, state agencies or educational institutions. These programs allow parents, grandparents and even other family members and friends to help a designated beneficiary (for example, a child) save for college costs. One of the appealing features of a 529 savings plan is that money invested grows free of federal income tax when withdrawn for qualified higher education expenses such as tuition, books, and room and board. (Tax Treatment at a State level may vary. Please contact a Tax Advisor before investing.)

Although it is seldom recommended to use retirement savings for education financing, it is possible to use your Roth IRA . . . albeit that may sound bizarre. After all, why would anyone use a retirement account to save for education expenses when there are special accounts specifically designed to help plan for education costs? Here are some reasons why it may not be as crazy as you think.

 

Roth IRAs are not included as an asset on the FAFSA form

When a child goes to college, if the family wants to receive student aid, the filing of a Free Application for Federal Student Aid (FAFSA) is a requirement. There are well over 100 questions on the FAFSA form, many of which are financial in nature and designed to help calculate what’s known as the “expected family contribution” (EFC). The EFC is essentially the amount that Uncle Sam thinks a person should pay for their own education and is calculated, in part, based on the assets of a student and their parents.

When reporting assets on the FAFSA form, most assets, including 529 plans, are included in the calculation. That means that doing the “right” thing and diligently saving for a child’s education in a 529 plan — a plan expressly designed for that purpose — could end up increasing a client’s EFC, reducing or eliminating the amount of financial aid for which they would otherwise qualify. On the other hand, Roth IRAs — along with other retirement accounts — are not considered assets when determining a family’s EFC. There’s no cap to that amount either, so clients may actually be able to accumulate significant sums in Roth IRAs and still qualify for student aid for a child.

 

Roth IRAs are more flexible

As noted above, 529 plans are expressly designed for accumulating money that will be used to pay qualified higher education expenses, like college tuition. To encourage clients to contribute money to such an account, Congress created special tax breaks. As long as 529 plan distributions are used to pay qualified higher education expenses, distributions are 100 percent tax free (in some states, clients may also be entitled to a state income tax deduction). For example, if a client contributes $5,000 to a 529 plan and it grows to $20,000 by the time their child goes to college, the full $20,000 can be distributed tax and penalty free (provided it’s used to pay qualifying expenses).

That all sounds great — and it is — but if for some reason the funds in the 529 plan are not used for qualifying expenses, distributions can go from being tax free to being quite pricey. In addition to owing income tax on any gains, such distributions are assessed a 10 percent penalty. True, a 529 plan set up for one child’s benefit can be transferred to an account for another qualifying family member, but such a person does not always exist.

For obvious reasons, you should be encouraged to start saving for college as early as possible. But how are we supposed to know for sure, though, if our 5-year-old child is going to go to college? Or what if your child gets a scholarship? That could turn a tax-efficient account into a tax nightmare. If, instead of saving money in a 529 plan, you had saved the same money in a Roth IRA and no longer needed those funds for education, it’s an easy and tax-efficient transition to use those funds in retirement. If they actually do need to use the funds to pay for a child’s college expenses, the Roth IRA may even provide the same tax efficiencies as a 529 plan…which brings us to our next point.

Roth IRAs may provide the same tax-free treatment for distributions

The primary purpose of contributing funds to a 529 plan is to enjoy tax-free distributions for education purposes, but a Roth IRA often provides the exact same tax benefits. If individuals are over age 59½ at the time they take distributions from their Roth IRA, and they’ve had any Roth IRA for five years or longer, then anything they take out of their Roth IRAs will be 100 percent tax and penalty free. That’s true whether they use the funds for education-related expenses or for any other purpose.

Even if you are not age 59½ (or have not met the required holding period) at the time education-related expenses need to be paid, they may still be able to take funds out of your Roth IRA tax and penalty free. Roth IRA contributions can be distributed at any age, and at any time, 100 percent tax and penalty free. So, for instance, if they contribute $5,000 per year to a Roth IRA for the next 10 years before their child goes to college (and take no distributions in the interim), at the very worst, they’d be able to take $50,000 tax and penalty free from their Roth IRA. (Future tax laws can change anytime and may impact the benefits of Roth IRAs – their tax treatment may change.)

The importance of saving early for a large financial goal like college or retirement can’t be overstated. The earlier you begin saving, the more time your money has to grow. While loans can be useful in bridging the gap between savings and final costs, a college degree doesn’t have to come with a mountain of debt. Ultimately, college affordability and success are the culmination of many little steps, which include guiding your child to finish his or her degree on time (or early), taking summer courses, living at home, selecting an affordable institution, carefully choosing a major, and carefully charting out a course load. Develop a multi-step strategy, which may include a 529 plan or other savings vehicle, and hopefully you or your children can enjoy the fruits of a college education for decades to come.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual

 

Jeffery Masters is president of Jeffery W. Masters & Associates 954-977-5150. Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Independent Financial Partners, a registered investment advisor. Independent Financial Partners and Jeffery W. Masters & Associates are separate entities’ from LPL Financial – Jeffery.Masters@LPL.com

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