The last couple of posts we have focused on the two tax-favored accounts, the 529 plan and the Educational Savings Account. Today we’ll look at other alternatives. One that some planners talk about is the Roth IRA. Both the ESA and the 529 plan work like the Roth; you make non-deductible contributions to each type of account, and if used for their designated purposes then the earnings are tax-free.
The Roth, although designed for retirement savings, can be used for college also as long as the earnings remain untouched. An individual can save up to $5,000 per year in a Roth IRA, so both parents of a child can save up to $10,000 per year in their Roth account. If the parents have no other college savings but decide that they want to pay for college, then these contributions can be withdrawn without tax and without penalty for that purpose. As long as the parents don’t touch the earnings inside of their Roth, then they would fit this scenario. This can also be part of an intentional plan for college, particularly if you are unsure whether you want to pay for college or not. If your child earns scholarships or does not go to college, then you have this money still working for you as retirement savings. But this should be used as a last resort, in my opinion, because it is more important for you as an adult to save for your retirement than for college for your child. The more money you take out for college, the less you have working for you to earn money for retirement. Another consideration for using the Roth is when you apply for federal student aid. Money that is in the parents retirement savings accounts do not count as assets under the current formula for determining student financial need.
Another way to save for college is through a regular mutual fund, money market, CD or savings account. You do not get the advantage of tax-free growth in these accounts, but what you do retain is full control of the account and discretion to do what you want with the money whenever you want to use it. Again, if you are unsure of your child’s college future or your willingness to pay for school, then this can be an excellent vehicle to put money aside which can be accessed for school. However, unlike the Roth option this money is fully counted as assets in the federal financial aid calculations.
So, with all of these choices, what is the best way to go? Here is a list that you might use to help you make the best decision:
- Evaluate the cost of college using the college savings spreadsheet.
- Decide if you are saving for college for your child. If not, that is OK but be sure to have open discussions on a regular basis with your child.
- If you are saving for college, are you financially ready to do so? Are you debt-free except for the mortgage, do you have an emergency fund, and are you saving for college? If not, get there first. It is more important to take care of yourself first.
- Once you are financially ready, and you have decided you do want to save for college, do you want to retain ownership of some or all of the college savings? If so, explore the options of regular savings or Roth IRAs as alternative options to retain ownership and discretion over your savings.
- Do you want a nearly-guaranteed account that pays just tuition and fees? If so, is there a 529 prepaid tuition plan in your state and is it in good financial shape? If so, is your child young enough to open an account? If the answers to all of these are yes, then open a 529 prepaid tuition account in your state.
- If you are creating dedicated college savings, look at your household income. If it is below the thresholds for ESA requirements, begin by saving up to $2,000 per year in an ESA. If that is enough based on your projections from step 1, continue to fund that yearly and monitor performance.
- If your income exceeds ESA limits, or if the ESA savings will not reach your college savings goals, save in a 529 plan up to the maximum allowable based on what you calculated in step 1. If the contributions to the 529 (and ESA if part of your plan) will meet your goal as calculated in step 1, continue to fund that yearly and monitor performance.
Whatever your stance on saving for college, it is extremely important for you and your child to understand the costs of college and the savings vehicles available to you.