Why the Roth IRA is a good way to save for college
As college costs continue to rise, American families are looking for the most effective way to save for education expenses. Their primary college-saving options are the聽聽and the聽.
In the battle for education-funding supremacy, these two investment vehicles can be likened to George Foreman and the late Muhammad Ali, 鈥渢he Greatest,鈥� who faced off in a聽legendary 1974 boxing match in Kinshasa, Zaire. The battle between Foreman and Ali pitted a younger, more powerful slugger against a smaller, more versatile boxer who had the wisdom and flexibility to adjust to the task at hand.
Foreman was favored due to his great strength and immense size, but he could do only one thing. Ali used Foreman鈥檚 size against him, tiring him out with what became known as the 鈥渞ope-a-dope.鈥� Resting on the ropes, Ali covered himself while Foreman consumed all his energy throwing punches that earned no points. Foreman鈥檚 inability to do anything but outmuscle his opponent ultimately led to his downfall. Fatigue set in, and Ali claimed the victory.
When it comes to battling college funding, if you want a big-muscled powerhouse that can do one thing 鈥� fund education 鈥� then the 529 plan is for you. But if you want a flexible fighter that can do many things and finesse an overall financial victory, then the Roth IRA may be your best bet. As a general rule, most parents should max out their Roth first then look at funding a 529 plan. But if you can contribute to only one, there is little doubt that the flexible and customizable Roth would be the best choice.
Both 529 plans and Roth IRAs are funded with post-tax dollars, but a Roth IRA is the better college-funding fighter for three key reasons: Flexibility, access to investments, and its impact on financial aid calculations.
Roth IRA advantages
Flexibility
Many 30-something couples have just paid off their student loans and now need to balance building an emergency fund, saving for retirement and saving for college. Well, the Roth IRA is about to throw a three-punch combination that will leave the 529 plan on the mat:
- Your contributions to a Roth are available to you anytime tax- and penalty-free. This is the right-hand, emergency-fund jab, the same type of jabs that stunned Foreman.
- The distribution of earnings from your Roth IRA for qualified education expenses is exempt from the 10% early-withdrawal penalty. This is the right hook that set Foreman up for his downfall.
- The tax- and penalty-free withdrawal of contributions and earnings after age 59陆 (and after at least five years since your first Roth contribution) is the finishing, retirement-funding left hook.
Investment choices
Just like Ali had a wide array of punches, stances and boxing styles, the Roth has a wide array of investment choices to get the job done. The 529 is limited by what the particular state that sponsors it chooses; like Foreman, the 529 plan is a聽powerful slugger, not a deft boxer.
The choices for the Roth are almost unlimited. This has value beyond just fees and performance. Roths can hold mutual funds, individual stocks and bonds,聽聽and even聽. I find some clients really like the ability to have a certain amount of funds in fixed-maturity assets for college. I often put together bond or ETF ladders for a portion of their assets. These kind of tailored strategies are not possible with 529 plans.
Value of assets on FAFSA
Roth IRA accounts, like all retirement accounts, are not counted as assets on the聽, which means the value of your Roth IRA won鈥檛 hurt your child鈥檚 financial aid eligibility.
The account value of a 529 plan, whether owned by the student or the parent, is considered a parental asset on the FAFSA, and 5.64% of a parent鈥檚 assets count toward his or her聽聽for paying for college expenses. This percentage is lower than that for accounts that are considered the student鈥檚 assets, which are assessed at 20%. A lower EFC means your student will be eligible for more financial aid.
529 plan strengths
Though the Roth IRA is a great all-around investing and saving tool that can help pay for college, 529 plans do have some distinct advantages when it comes to contribution and income limits and taxation.
Contribution and income limits
Much like Foreman, the 529 plan鈥檚 advantage is in its size. The annual contribution limit for the 529 plan is $14,000 ($28,000 for married couples) with no income limits, compared with $5,500 for the Roth. (The $14,000 is the annual gift-tax exclusion amount and incurs no tax, has no filing requirement and does not eat into the lifetime estate basic exclusion amount.) Lifetime聽聽can vary by state but are high, ranging from $235,000 to $400,000.
On the other hand, married couples filing jointly with a聽聽of less than $184,000 can contribute the maximum amount of $5,500 to a Roth IRA. But the聽聽is reduced for those with MAGIs of $184,000 to $193,999 and phased out completely for couples with MAGIs of $194,000 and above.聽Savers 50 and over may be able to make catch-up contributions of $1,000 per individual, for a total of $6,500.
State tax credits or deductions
Some states do offer state tax credits or deductions for contributions for residents who invest in their home state鈥檚 529 plan. The聽Roth does not have this benefit. Much like a 401(k) employer match, it鈥檚 essentially free money if your state offers it.
Withdrawals treated more favorably on FAFSA
Qualified withdrawals from parent or student-owned 529 accounts are excluded from federal income tax returns and do not have to be added back to base-year income on the following year鈥檚 FAFSA. (This is not true for 529 plans held by grandparents or other relatives, so be careful. Lack of communication between parents and grandparents can result in the opposite of the intended effect.)
When you take earnings (not contributions) out from your Roth to pay for college, it will be counted as student income on the following year鈥檚 FAFSA. This can reduce a student鈥檚 aid eligibility significantly, since 50% of a student鈥檚 income is considered an available resource to pay for college when calculating financial aid.
Lessons from Ali
In most cases using both account types is the best option. Like having access to the large, muscular power puncher and to the versatile, skilled boxer in a fight, you get the best of both worlds. But if you have to choose one tool to save for college, I recommend the Roth. Much like Ali鈥檚 ability to adapt to his opponent, the agile, quick-moving Roth can give you a step up on college savings.
As we mourn the loss of a man whom Foreman eventually called 鈥渢he greatest man I鈥檝e ever known,鈥� we should bask in the glow of Ali鈥檚聽courage and accomplishments and learn from his clever approach to an incredible challenge.
, CFA, CFP, is a fee-only planner with聽聽in Chanhassen, Minnesota.
This article first appeared at .
