With college costs rising at an average annual rate of 6.5% (since 1983 according to J.P. Morgan), the best advice on college savings is to save early and save as much as you can. But when it comes to choosing how to save, what should you consider?
The best vehicle for college savings depends on your purpose or objective. Experts agree that if you expect your child or grandchild will attend a two or four year college, the best way to save for that expense is to open a 529 Savings Plan (“529”). However, if your objective is to save for future education expenses and maximize flexibility, you should also consider using a Roth IRA (“Roth”) or a taxable account in addition to a 529.
529 Savings Plans
529s were designed for education savings and allow after-tax contributions to grow tax free and be distributed tax free if used for qualified education expenses (which include tuition, room & board, books and computers). There are no income restrictions on contributions to a 529 and some states offer a tax deduction or credit for contributions.
Individual contributions are limited to the annual gift tax exclusion amount ($15,000 in 2018), but the IRS also allows individuals to front load up to five years of contributions ($75,000 in 2018) using the gift tax exclusion.
For financial aid purposes, a 529 owned by a parent or the student will be treated as a parent asset and assessed at 5.64% rate when calculating the expected family contribution.
If the child does not use all of the 529 assets, the beneficiary can be changed to another relative, or assets can be withdrawn (in which case, earnings will be taxed as income and subject to a 10 percent penalty). If the child receives a scholarship, an equivalent amount can be withdrawn from the 529 without penalty but earnings would be taxed as income.
Roth IRA Accounts
For more flexibility in saving for college, a parent with earned income can open and fund a Roth IRA. Roths were created for retirement savings and offer a wide variety of investment options; however, similar to a 529, individuals can make after-tax contributions to a Roth and assets grow tax free and can be withdrawn tax and penalty free if used for education purposes (if the account is more than five years old). Contributions to a Roth are limited to $5,500 per year (or $6,500 if owner is at least 50 years old) and subject to income limitations.
For financial aid purposes, Roths are treated as retirement assets and excluded when calculating the expected family contribution; however, withdrawals from a parent-owned Roth to pay education expenses are treated as income to the parent and will increase the future expected family contribution. The optimal time to withdraw from a Roth to pay education expenses without affecting financial aid eligibility is after the child completes his/her second year of college. Roth assets not used for education purposes can be saved for retirement.
If you surpass the Roth IRA income limit and are looking for ways to increase your college savings over and above a 529, consider using a taxable account. Taxable accounts don’t have the tax benefits (tax-deferred growth and tax-free withdrawals for education expenses) of a 529 or Roth; however, investing in tax-efficient assets focused on long-term growth can help minimize the tax liability.
If the taxable account is titled in a parent’s name, the parent will maintain control over the assets (if, for example, the child decides not to attend college) and can use the funds for other purposes. For financial aid, the assets will be assessed at 5.64% rate when calculating the expected family contribution.
If the objective is to transfer the funds to the child (regardless of how the assets are used), then the taxable account should be titled as a custodial account so that the parent or grandparent can contribute to the account using the annual gift tax exclusion. As a custodial account, earnings in the account will be taxed using the trust and estates tax brackets, and the child will have full control over the assets once the child reaches the age of majority. Titling the taxable account as a custodial account is not optimal if the child will apply for financial aid because the account will be treated as the child’s assets and assessed at a 20% rate when calculating the expected family contribution.
The 529 Savings Plan is the best vehicle for college savings but the Roth IRA and taxable account options offer more flexibility. The most important thing is to choose a vehicle that fits your needs and save early so when it comes time to pay the college bill, you are prepared!