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Using a Roth IRA to Save for College
Over the past couple years, my thinking regarding the best way to save for college has changed somewhat. The early signs of that change appeared in the April 2004 article Saving for College — 21st Century Style, which profiled the still relatively new Coverdell Education Savings Accounts, as well as their primary competition, the state-run Section 529 Plans. In that article, I advocated funding a Coverdell Education Savings Account first (if you're eligible), and using a 529 plan as a second-choice "backup plan." Since then, my thinking has continued to evolve in this direction, as I'll explain in a moment.
Why the change away from 529 plans? After all, a few short years ago they were the hot new tool for college saving, and were being recommended left and right (including here at Sound Mind Investing). But changes in recent years have made 529 plans less attractive:
1. Tax law changes made Coverdell ESA's more attractive. Raising the contribution limit to $2,000 per child, per year made Coverdells a much more viable alternative to 529 plans. Lots of young families can't afford to save more than that for college anyway. Being able to use the proceeds for private school before college also helped increase their appeal.
2. 529 plans became largely broker-sold. That's not to say you can't invest directly in a 529 without a broker you can. But the majority of new 529 plan money is coming through brokers. In most cases, paying the resulting sales loads blows the 529 plan advantages.
3. Expenses have gone higher and investment options are quite limited. This was supposed to work the other way, with expenses declining as more assets piled into these plans. While I don't have any hard evidence that expenses are higher on average across the board, I do see a lot of plans with outrageously high expenses (1.5% and up). High expenses in a 529 plan where you don't have the advantage of being able to upgrade between funds are the kiss of death. To some extent, the rise of broker-sold 529s has likely contributed to investors losing track of what these investments cost. Likewise, the lack of good investing choices in many plans is directly attributable to many states locking into a particular fund company as the plan sponsor. Big bucks for the state, but less flexibility and often poorer choices for the investor.
4. States are playing games with 529 tax treatment. Because 529 plans have become big business, states are playing hardball to "encourage" their residents to invest in the home state 529. How? States are increasingly making distributions from their own 529 plan free of state tax, while taxing distributions from other 529 plans. Those investors often face a lousy choice: invest in their state's sub par plan, or face a 4%-8% tax hit on the back end.
5. The tax-free nature of 529 gains looks more in doubt than before. When the tax act of 2001 was passed, granting 529 earnings federal tax-exempt status if used for education expenses, it seemed like a slam-dunk this treatment would be made permanent before the "sunset" date in 2010. Now that we're more than half way to the point when earnings will revert to being taxable at the student's rate, it looks less certain this will be extended.
For all these reasons, 529 plans have gradually become less appealing. Make no mistake, they still make sense for certain savers: those whose high incomes make them ineligible to contribute to a Coverdell or Roth IRA, or those who simply want to save more each year than these accounts allow. For those folks, I definitely encourage reading up on selecting top 529 plans and pursuing that option. Sound Mind Investing has long favored 529 plans that focus on low-cost index funds as their primary investment choice.
For most young families though, I've come to believe the Coverdell ESA is a better alternative to the 529 plan. And there may be an even better option than the Coverdell ESA. At this point, I think it makes a lot of sense to fully fund a Roth IRA for each parent every year before putting any money into Coverdell accounts. The reasons are pretty simple:
• No one will lend you money for retirement. However, they will lend your child money for college. I understand the point of saving for college is to hopefully avoid the need for your child to borrow. But bumps in the financial road do happen sometimes, and the bottom line is that if it comes down to an either/or situation, it's more important that you have a reasonable level of retirement savings than a large college savings fund.
• The tax advantage of saving for college in a Roth is nearly as good. While you won't get tax-free treatment on earnings saved in a Roth (if used for college), you can withdraw your contributions for college expenses without tax or penalty. The obvious solution is to leave your earnings in the Roth for retirement and withdraw the principal to pay college bills.
• Flexibility. If junior doesn't go to college, gets a scholarship, or whatever, there's no need to move your savings around to a different type of account if it's already in a Roth IRA. It's already in the most tax-advantaged spot for your retirement savings to be. This can be a big issue, since the annual contribution limits for the Roth would likely keep you from being able to transfer large sums from a college-specific account into a Roth down the road. And if you're fortunate enough to be making big bucks by the time the kids go to college, you can pay the college bills out of current income and keep the full Roth IRA intact (since you may no longer be eligible to make new contributions to a Roth due to your high income).
• Contribution limits. With the annual limit for the Roth IRA increasing to $4,000 in 2005, a married couple can save a full $8,000 (more if they’re age 50+) per year in Roth IRAs. Many families with kids aren't going to be able to save more than that anyway, and if they can, the Coverdell accounts are still available to save an extra $2,000 per child per year.
• Financial aid and education tax credits. While the treatment of college accounts for financial aid and tax credit purposes is a messy topic, suffice it to say that having college savings money held in your Roth IRA is going to simplify the treatment of both of these issues down the road.
For most families then, I'd recommend saving for college this way: fully fund Roth IRAs for both parents each year, and if you have additional money available to save for college, fund Coverdell ESAs for each child. Only then would I look at 529 plans. The exception to this rule would be residents of the rare state 529 plan that offers exceptional tax benefits on contributions, as well as a solid lineup of index fund investment choices. Those residents may want to utilize their home-state 529 plan sooner in their overall savings plan.
That's a little different strategy than what we've recommended to college savers in the past, but changing times call for changing plans, and this seems to make the most sense for the average young family at present.
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