In the best-timed article of the year, we covered 529 College Savings plans on 5/29. During that assignment, the Wallet Blog editor asked how a 529 plan stacked up against that other popular savings vehicle for higher education: the Roth IRA. I contacted Timothy Parros, CCPS, HECA, NACAC of Parros Financial Group & Parros College Planning in Ann Arbor, MI, to get the scoop.
Beating the FAFSA
It’s important to recognize which assets belong to parents and which belong to children before completing The Free Application for Federal Student Aid (FAFSA) form for your child.
Many parents don’t realize that a 529 College Savings plan that they’ve funded for a child is actually considered a parental asset, which could count against them at FAFSA time.
“The number-one benefit of a Roth IRA is that it doesn’t count on a FAFSA. A 529 will count as a parental liquid asset —unless you come in under the parental income/asset/age limits— but a Roth IRA will not,” Parros said.
Note: the cash value of life insurance and annuities do not count as assets on a FAFSA form, either.
Roth IRA Benefits
“Another nice thing about a Roth IRA is that if your kids choose not to attend college, you can use it as a retirement fund for yourself, but you don’t have to take mandatory disbursements from your Roth once you reach age 70-and-a-half like you do with traditional IRA plans,” Parros said.
“Also, if your child chooses to attend college, and you’re under age 59-and-a-half, you will have to pay taxes on the growth but won’t have to pay penalties for early withdrawal,” Parros said.
Roth IRA Disadvantage
The problem with choosing to save for college with a Roth IRA is that some people are closed out of the process, based upon their yearly income.
“You can fully fund a Roth IRA if you’re married filing jointly and earn under $178,000 yearly. After that, you’re gradually phased out from $178,000 to $188,000. Once you’re earning $188,000 on your married-filing-jointly tax return, you can’t do a Roth IRA,” Parros said.
“If you’re single, the phase-out starts at $112,000 and you’re closed out once you reach $127,000 in yearly income,” Parros said.
The best option for keeping a 529 College Savings Plan out of the eyes of FAFSA is to ask a trusted grandparent, relative, or friend to put it in their name, designating your child as the beneficiary.
“That’s the best way to structure the 529 plan,” Parros said. “Of course, if you want to put your own money into it, then someone else has the control over it.”
Parros says that many parents take the money a child receives for birthdays and holidays and puts those funds into grandma or grandpa’s 529 plan.
Another benefit of using a 529 as a college-savings vehicle is if your child chooses not to attend college, you can hang on to the plan and change the beneficiary to your future grandchild[ren].
“The 529 plans are tax-free and penalty-free when spent on higher education. If your kids choose not to go to college, or if they go to college but most if it is paid for through scholarships, then you can keep the 529 for a grandchild. That way, you’ve already started a legacy for the grandkids,” Parros said.
Besides counting as a liquid asset if you fund a 529 plan for your child under your name, there are severe penalties for spending 529 funds on something other than higher education.
“If your kids don’t go to college and you want to use that 529 money for your retirement, you’ll have to pay a 10% penalty for not using the funds for higher education, plus you’ll have to pay taxes on the growth. So, if you’re in a 25% tax bracket, and your funded-at-$10,000 529 plan is now worth $20,000, you’ll pay $3500 in taxes and penalties for cashing out the plan,” Parros said.
This is a big reason why Parros thinks the Roth IRA “is the better way to go.” Between the FAFSA benefit and the no-penalties for hanging on to a Roth IRA for retirement if the money isn’t used for college, Parros suggests that his clients go the Roth IRA route – if their income isn’t so high as to bar them from participating.