Why A 529 Plan Is The Best Way to Prepare Your Family For College Expenses

529 College Savings Plan and FAFSA
 

 

It isn’t surprising that an investment plan created for the express purpose of helping parents save for their children’s college would be the best way to save for college. However, there are still some who question whether there is a better route. Some parents look to save in a taxable investment account or Roth IRA. But is it really more efficient? Today, we will tackle whether the 529 really is the gold standard for college savings.

 

 

529 Plans Offer Tax-Free Earnings Growth

When you save money in a 529, you are contributing after-tax income dollars. However, any growth seen in your 529 investments can be accessed tax-free, as long as it is used for qualified education expenses. (And these expenses are defined more broadly than many people think.)

 

Alternatively, if you save in a taxable investment account, your growth is subject to capital gains tax. This means even if you put away the same amount for your child’s education in a taxable account, you’ll have less to actually contribute to their education. Also, the higher investment returns you see between the time you contribute funds and when your child starts college, the greater your tax liability. So, the greater your returns, the more beneficial the 529 becomes.

 

 

College Savings 529 Plan vs. Roth IRA vs. Regular Savings

 

 

Now, some may say you can achieve the same tax-free earnings growth in a Roth IRA. However, you can only access principle (i.e. the dollars you put in, not the growth) from your Roth IRA for college expenses if you are under 59 when your child is in school. Otherwise, you still owe a 10% tax penalty on the gains as well as ordinary income tax. Personally, I’ll be 44 when my youngest starts college and 46 when my second reaches that stage. Making a Roth IRA much less attractive.

 

 

 

Even if you are over 59 ½ when your child starts college and can access any amount, the impact on FAFSA isn’t the same as a 529 Plan. This brings us to the next benefit of the 529!

 

 

 

 

529 Plans Have a Lower Impact on FAFSA than Roth IRAs

Some parents are reticent to save in a 529 Plan because any investment counts as an asset for the FAFSA and other aid forms. And this is true. But it isn’t treated any more harshly than a taxable investment account. Both are treated as parent assets, with only 5.64% of the account’s value counted towards your ability to pay for your child’s college.

 

 

 

It is a common misconception that Roth IRAs shield college savings from negatively impacting financial aid awards. However, Roth IRAs can have a much higher impact than a 529 Plan after your child’s first two years of school. Yes, as a retirement account, the assets are not included in FAFSA calculations in your child’s first year. But then distributions are treated as untaxed income and added to AGI. FAFSA and other financial aid can expect up to 50% of untaxed income be attributable to college expenses. Due to FAFSA being based on earnings two years prior, the distribution you take for you child’s freshman year is not counted in their sophomore FAFSA. But you get hit by the full 50% in your child’s junior and senior years.

 

 

529 Plan Affecting Financial Aid FAFSA

 

 

For example, let’s assume a family withdrew $15,000 from a Roth IRA to pay for college expenses in their child’s freshman and sophomore years. In the following year, FAFSA would count that $15,000 as untaxed income. Aid eligibility would be reduced by almost $7,500 for the child’s junior year. This would mean withdrawing even more in child’s third year due to lower aid grants.

Alternatively, 529 Plans have modestly lower impacts on FAFSA as the child progresses through school. This is because each year the account’s value depletes, making 5.64% of that number a smaller hit to aid eligibility. This makes it a much better choice than a Roth IRA if you plan to also apply for financial aid.

 

 

Avoiding the FAFSA Penalty With a Roth IRA

Unsurprisingly, there are loopholes to almost every rule. Using other sources of funds, outside of a Roth IRA, in your child’s freshman and sophomore years would remove any FAFSA impact of Roth IRA savings or distributions. This is because the FAFSA looks at income from two years prior.

 

For this to be attractive, parents would have to be over 59 ½ when their kids start school due to the distribution penalties of Roth investment gains listed above. Then, if parents are the only ones helping a student pay for school, they would also have to save enough in an 529 to help pay cash needs in the first two years of school.

 

But what about grandparents who want to contribute to their grandchild’s college expenses? Given the tax-free withdrawal of Roth contributions and gains past the age of 59 ½, this could make the Roth a better savings vehicle than a 529 for working grandparents. Parents could save in an 529 for the child’s freshman and sophomore years, with grandparents only contributing in their last years of schooling. In addition, if the grandparents decide not to help their grandchild for any reason, or if their grandchild doesn’t finish school, that money can be saved for their own retirement.

 

Keep in mind, however, that Roth IRAs still have other restrictions to consider. For parents, eligibility for investing in a Roth phases out with income level. There is also a $5,500 annual cap on contributions, versus $14,000 for 529 Plans (dictated by the annual gift limit). For grandparents, Roth contributions can only be made if you are still working. For already retired grandparents, a 529 or taxable account would be the only option.

 

Your State’s 529 Plan May Offer a State Tax Deduction for Saving

Finally, 32 states and D.C. currently offer state tax deductions for contributing to a 529 Plan. The absolute dollar benefits are relatively small for most families. However, it is better than the zero-dollar tax deduction benefit for saving in a taxable account or Roth IRA.

 

States with 529 Tax Deductions

 

 

 

For example, let’s continue the assumption that a family is saving $3,000 a year for their child’s education. The state tax deduction is worth, on average, about $107 a year across the 33 jurisdictions that offer one. While this isn’t much, over ten plus years of saving for your child’s education, it does add up. A nice little bonus benefit to the other positives of saving in a 529 highlighted above!

If You Know Your Child Is Going to College, a 529 is the Best Way to Save

529 Plans are made to help families save for college, and they do a pretty great job. Over time, you will have the most significant available assets to pay for college, have only a minimal impact on financial aid eligibility, and could reduce your tax liability. If you are confident your child will go on to pursue higher education, a 529 will put your family in the best financial position.

 

 

 

CONNECT WITH OTHER PARENTS FIGURING OUT HOW TO PAY FOR COLLEGE

JOIN OUR FACEBOOK GROUPS – PAYING FOR COLLEGE 101

 

 

 

 

By Chelsea Brennan, a personal finance writer and content marketer who left a career in investment management to pursue a goal of improving financial literacy for families. Brennan shares her obsession with budgeting, investing, and raising financially smart kids at Mama Fish Saves.

SaveSave

SaveSaveSaveSaveSaveSave

SaveSave

SaveSave

SaveSave

SaveSave

SaveSaveSaveSave

SaveSave

  1. […] a third will be going soon. If you want to find the money to set aside in a savings account or in a 529 plan, here are seven things you can […]

    Reply

Leave a Reply

Your email address will not be published.