I’ve given a huge rant on why I don’t think you should use a 529 to save for college. I’ve laid out the scenario of when you still might choose to start a 529 savings account. Now you might be wondering what steps you should take to prepare for future college expenses. The answer is quite simple: open a Roth IRA.
When you open a 529 account, you do not get any deduction on your federal taxes. However, as the money grows, you never pay taxes on the growth – provided you use it to pay qualified education expenses. The mere fact that the growth will not be taxed is the only advantage that a 529 has. The ROTH IRA has the exact same attribute, but without many of the restrictions that make the 529 so unappealing.
The IRA was conceived to be a retirement account: Individual Retirement Arrangement. At age 59 1/2, you can take out funds completely tax and penalty free, as long as your IRA was started at least 5 years ago. Taking it out early would incur some penalties, but there are notable exceptions. Among the exceptions is using your IRA to pay for college. You can use your ROTH IRA to pay for college for yourself or your children with NO penalties or tax consequences. Exactly the same way a 529 works.
However, there are additional benefits to placing college savings in an IRA over the 529 account.
You will still be eligible to receive education credits such as the Lifetime Learning Credit or American Opportunity Credit if funds are taken from your IRA. If you use funds from a 529 Account for education expenses, these same expenses will not be counted when you calculate the credit. Remember, the American Opportunity Credit alone is worth $10,000 in tax savings.
By law, money saved in retirement accounts (such as the IRA or a 401K) are not included in the FAFSA calculations to determine federal student aid. On the other hand, money saved in a 529 account counts heavily against the student aid that will be made available. FAFSA also examines your adjusted gross income, as shown on your 1040, to calculate student aid. Money taken from a ROTH IRA for education benefits will not be taxed and will not be included in your adjusted gross income.
Because the government wants people to plan for their retirement, they first offered the Saver’s Credit in 2002 as an incentive to the populace to take an active role in their financial security. Depending on your income, you could save up to $1,000 off your taxes for saving money in an IRA, a 401K or a 403B. Once again, the 529 is not eligible for this credit.
Finally, (and this is BIG) you are not limiting your scarce investment resources to pay for just one scenario. If you do not need the money for college, the money you saved in the ROTH IRA is still available for your own personal retirement. It is your own account in your own name. There will be no penalty when you take it out for retirement. There will be no taxes when you do take it at retirement. However, that money had been available to be used exactly the same as if it were in a 529 account if you had needed it.
- Your education tax credits are not limited because you used funds from a 529 account.
- Your federal student grants and loans have not been decreased because you have funds in a 529 account.
- You can use funds earmarked for education in your ROTH IRA to receive the Saver’s credit.
- You can use the funds originally saved for education for anything you want if they were placed in a ROTH IRA (subject to age requirements).
- You have not limited your options at all.
But you have saved.