A key component of your college savings plan, the 529 Plan may be not really be a smart option at all, and that goes for a number of similar savings vehicles being routinely recommended for parents with college-bound kids.
Read any article about how to save for your kids’ college expenses and you get the same advice every time… Education IRAs and 529 Plans. This advice is dispensed so ubiquitously that consumers and financial professionals alike have accepted it as a foregone conclusion, and something everyone should automatically include in their financial plan. Ironically, such plans make sense for only a very few, and the vast majority of us might be better off without participating in them at all.
The idea behind Education IRAs (aka Coverdell ESAs) and 529 Plans is that any money you put in them will grow tax-free, and the money you withdraw to pay for qualified college expenses will be tax-free at the time you withdraw it. Sound familiar? It’s exactly the same concept as the Roth IRA, the difference being that the money is earmarked for college rather than retirement. Like the Roth IRA, if you make a non-qualified withdraw from an Education IRA or 529 Plan, you’ll pay both income tax and a 10% penalty on any earnings that accumulated while the money was in the plan.
We’re told repeatedly by the financial industry that these plans are an excellent way to save money by sheltering it from Uncle Sam. In fact, the opposite is true. Those families who might qualify for financial aid (and that includes most of us) will be in for a bit of a shock the year their first child applies for college…
One bit of financial planning advice that should be followed by everyone is to apply online for federal student aid (via FAFSA at www.fafsa.ed.gov) the year you begin applying at colleges. The application is free and is used by both state and federal governments as well as most public and private schools to determine eligibility for what is effectively a discount on your tuition. Most middle-income families will qualify for something, unless your income is too high, or your college-available savings are too high. What are your college-available savings? They basically include any assets that aren’t earmarked for something else. They do not include your home, your pensions, your 401k Plans, or your IRAs (both traditional and Roth). But guess what is included… All the money you so diligently saved in your Coverdells, Education IRAs and 529 Plans will be counted against you as schools determine how much you should be charged for your child’s attendance. In fact, if you’ve saved enough money to pay the entire tuition, you will get no break at all, while your less responsible next-door neighbors will get a discount because they haven’t saved enough to pay the full amount. The discount can be substantial, amounting to thousands of dollars each year.
But what about the special tax advantages of these plans? The bottom-line answer is, you get the same tax advantage from a Roth IRA. A little-known fact about Roth IRAs is that the IRS allows you to make tax-and-penalty-free withdrawals before you are 59½ to pay for qualified education expenses! That means you can use your Roth IRA exactly the same way you would use an Education IRA or 529 Plan, with exactly the same benefit (a similar provision exists for traditional IRAs as well, allowing you to withdraw money early to pay for college without a 10% penalty). The only difference between using Roth money versus an education plan is that putting it in an education plan makes it count against you at financial aid time.
Many advisors recommend 529 Plans claiming they are a good way to “catch up” if you haven’t stashed enough in another tax-sheltered plan. Unlike Roth IRAs, 529 Plans have no contribution limits, thus you can put $30,000 in a plan two years before your kids are ready to go to college, and get a tax savings on the two years of earnings they will produce. That’s fine advice for those who have $30,000 of surplus money laying around in an unsheltered savings account that they can’t find anything else to do with. But for the vast majority of us, there are better ways of preparing for college, even if we start only two years in advance.
Contribute the maximum to your traditional and Roth IRAs. In two “catch-up” years, you and your spouse can contribute nearly $20,000 to IRAs. Since you’ll be pulling that money back out to pay for college in two years anyway, you won’t be locking it up any more than if you did nothing, you’ll get the same (or similar) tax break you would with a 529 plan, it isn’t restricted to school costs, and you’ll be sheltering it from the financial aid eligibility exam.
Convert old 401k Plans to IRAs. Any 401k Plan from a previous employer can be converted to an IRA, often with little more than a phone call. This is generally a good thing to do anyway because an IRA provides more flexibility than a 401k. Once the money is in an IRA, it can be tapped to pay college expenses without penalty.
Pay down your mortgage. Your home is not included in college-available savings when you’re being considered for federal financial aid. If you have $80,000 saved in an unsheltered savings account for college expenses, and you have $50,000 in a Roth IRA, consider paying $50,000 of the college savings towards your mortgage and using the Roth money to pay for college instead. You’ll shelter $50,000 from financial aid consideration, and in the end, you will have transferred your Roth savings to your home, which actually provides a better tax shelter than the Roth.
It is also a good idea not to put money in your child’s name (most advisors already preach this) because that is also counted against you when applying for financial aid.
So who can benefit from a 529 Plan? Those who’s income is so high they won’t qualify for financial aid under any circumstances or who have a large amount of unsheltered money that can’t be sheltered any other way. For those people, a 529 Plan might be the best option if they start early enough to make it worthwhile. The paradox is, the earlier you start, the less sense 529 Plans make (since IRAs provide tax benefits without disqualifying you for financial aid), and the later you start, the less benefit they provide. Considering the paperwork, restrictions, state-to-state differences, and the financial aid factor, I rarely advise such plans for anyone. My advice: save for college the way you save for everything else; start early, stick to your IRAs, and keep it simple!