We’re beginning the second full week of being back to school within the Anchorage School District and many friends of mine, including our wonderful summer interns Victor and Tanner, are snagging seats on big metal birds to get back to the grind at their universities.
If you are the parent of these students, however, you know that education is expensive and continually outpacing the core CPI index’s inflation. The chart below only tracks through 2017, but the disparity is still staggering.
Two popular investment vehicles for education funding are the 529 Savings Plan, and Roth IRAs. Clients, friends and family often ask, “Which is better?” In short, the answer is that funding both keeps you on track for retirement and your kids on track for college. But, what if you have limited dollars and you must choose?
529 Savings Plan
Taxes and Withdrawals: This account harbors after-tax contributions that grow tax free so long as they are used for educational expenses such as tuition, books, supplies, and others. There are also no income limit to contribute to a 529.
Investment Options: Investment options are typically more limited than retirement accounts both in selection and how often you can change the investments. They typically follow a “set it and forget it,” philosophy. There is another unique type of 529 investment option called Prepaid Tuition Plans that allow individuals to purchase future tuition at current rates. These accounts still fall under Section 529, but instead of applying to most education expenses, they only apply to tuition.
Contribution Limits: The aggregate limit to contribute to 529s vary by state. If you’re curious, Alaska’s limit states that the account balance cannot exceed $320,000. While it’s great that there aren’t any annual contribution limits for 529 plans, we should be mindful to avoid the federal gift tax. If you’re opting to avoid the tax, you should not contribute more than the 2022 gift tax limit of $16,000 and check that limit each year you contribute.
It should be noted, there is a provision that allows you to “front load” a 529 with 5 years of contributions without becoming subject to the gift tax. In essence and in accordance with current law, you could contribute $75,000 in one year if it made sense in your financial plan, and not contribute to the plan for the next four years. This is a compelling strategy to employ if you are starting a 529 for a younger child so that the money has more time to grow.
How do they affect the FAFSA? If you think your child might qualify for need-based financial aid then note that if the 529 is owned by the parents for the benefit of the child attending school, they get counted as parent assets and NOT student resource. This has a beneficial effect on the FAFSA when compared to a 529 not owned by a parent, (e.g., by grandparents) where withdrawals from the account are reported as student income.
Tax and Withdrawals: Roth IRAs, which also allow after-tax dollars to grow tax free have a provision that allows you to make unlimited tax-free withdrawals on the amount you have contributed to the account (and pay ordinary income tax on any earnings withdrawn) to pay for your child’s educational expenses such as tuition, books, supplies, and others. Note that you must have a Roth open for at least 5 years before you can take out the tax-free earnings.
Investment Options: You have access to broader investment options and no limits to changing your investment strategy. If you do not end up using the entirety of the Roth IRA, you can keep it growing for your retirement, and at age 59.5, you can withdraw from the account for any purpose.
Contribution Limits: The contribution limits in 2022 are quite low at $6,000 per year for individuals under age 50, and $7,000 for those over age 50. On top of the lower limits, there is a phaseout for high earners that can prevent contributing to this account type. If you are hitting that limit, or you need more, you can consider a large Roth conversion from a retirement plan at least 5 years before the education expense withdrawals start.
How do they affect the FAFSA? Roth IRAs are a parent-owned asset on the FAFSA, however the withdrawn funds can increase the parent income since they will show as untaxed income.
The Bottom Line
These are only two ways that you can fund a loved one’s education, and there is a myriad of others that also harbor provisions that must be intentionally and technically navigated. I always say that the favorite part of my job is being able to connect our clients with their goals, and our team of experienced financial advisors are versed in these different account types. Being able to support clients in providing their loved ones a bright future while meeting their goals is absolutely rewarding.
Associate Financial Advisor