The cost of a college education is rising by three to four percent a year, so it is never too early to start saving for your child’s future college tuition. Before you start saving however, make sure to consider the options that will maximize your savings while minimizing your tax burden.
A 529 plan allows you to contribute to a tax-advantaged account in order to fund college tuition. While contributions to a 529 plan do not provide a federal tax deduction, you may qualify for a deduction on your state tax return for your contributions. Additionally, you can pull out your contributions and earnings from the account tax free when you use them for qualified education expenses. Qualified education expenses include tuition, fees, books, supplies, and equipment required for enrollment. If your child is enrolled at least half-time (6 or more credit hours per semester), room and board are also considered to be qualified expenses.
529 plans come in two varieties: Prepaid tuition plans and college savings plans.
Prepaid Tuition Plan
With a prepaid tuition plan you can pay for your child’s tuition ahead of time, based on the current rates. For example, if your child is 8 and one year of qualifying college tuition is $10,000 today, you can contribute $10,000 to the fund today and your child’s first year of tuition will be fully covered when they start college in ten years – regardless of the cost of tuition at that time. You are not required to prepay a full year at once, you can pay into the fund over multiple years but each year the required amount will increase. With a prepaid tuition program, you do not need to worry about how well the fund is performing, or about tuition costs. The fund bears the risk, not you.
College Savings Plan
A college savings plan operates more like a traditional investment account such as an IRA or 401K. You contribute funds to the plan that grow over the years until you are ready to withdraw them to cover education expenses. While a college savings plan does not provide the same guarantee as a prepaid tuition plan, it provides more flexibility on how the funds are used. It also has the potential to provide a greater return on investment than the prepaid tuition plan where earnings of the account will be no greater than the rise in tuition cost.
Roth IRA as a Last Resort
If your child is about to enter college and you do not have a 529 plan in place to cover the tuition, you can pull funds from your Roth IRA without incurring the early penalties and taxes that you would normally face when taking early distributions. We caution against using a Roth IRA to cover your child’s college expenses, because the Roth IRA is one of your best retirement tools. It is however a valid option. If you choose to tap into your Roth IRA to cover education expenses you need to meet two requirements to avoid taxes on the distributions:
- Wait Five Years: You need to wait at least five years after first funding your Roth IRA before you withdraw any of the earnings of the account.
- Qualified Expenses: You must use the entire distribution for qualified education expenses. Be sure that you do not take out more than what is needed to cover these qualified expenses.
Failure to meet these two requirements will result in you paying the normal tax rate on the earnings of your account, effectively eliminating the tax benefit of your Roth account. Additionally, you will pay a 10% early withdrawal penalty on any distributions that don’t meet these requirements.
A 529 plan provides a tax-efficient way to save for your child’s college education. A Roth IRA can also provide tax-efficient savings for education, but your goal should be to not touch your Roth until you retire. You should consider all the options with the following priorities:
- In an ideal world, you would first max out your Roth IRA contribution of $5,500 per year (if you are married your spouse can contribute another $5,500 per year to their Roth).
- You would then contribute to a 529 college savings or prepaid tuition plan. (You should not contribute to a 529 plan if you have not already maxed out your Roth IRA as the 529 Plan creates more restrictions).
- If you cannot contribute to a Roth IRA due to income limitations, you can still contribute to a 529 plan.
Be sure to reach out to TAMCO if there are any questions about how to fund your children’s college education or the tax implications of an existing account. We are here to help you keep more of what you earn.