Published on September 10, 2020
When Saving for College, There's More Than One Game in Town
Written by The Servion Financial Advisors Team
September is National College Savings Month
When it comes to saving for college, it’s important to know all your options. Most people are familiar with a 529 plan, which is an account that allows you to save and invest money for college tuition, or other qualifying reasons. However, 529 plans aren’t necessarily the only game in town. There are a handful of other options, all of which have their pros and cons. In this article, we’ll do a quick compare and contrast of some of these savings methods.
529 Plans
529 plans are specifically designed to help families save for college: they do not have contribution limits, they are low maintenance, and parent-owned 529 plans get favorable financial aid treatment. Another benefit is that the funds in a 529 plan are tax-exempt if they are used for educational expenses. They also give you an opportunity to earn a higher return because you can invest in ways that may yield a higher return than a traditional savings account.
To reap the 529 plan’s tax benefits, you must use the money for college expenses, which is a restriction you’ll need to keep in mind. Secondary education (i.e. anything pre-college) expenses aren’t covered. Also, distributions from a 529 owned by anyone other than the student or parent count as income to the student, which can impact their ability to qualify for financial aid. Another downside is that without professional guidance, it may be difficult to choose the right places to invest. Without this help, it could cost you dearly.
Education Savings Accounts (ESAs)
Perhaps the biggest difference between an ESA and a 529 is that an ESA is not limited to college. In other words, an ESA can be used to pay for the cost of education not just for college but for secondary schooling as well. Plus, ESAs allow more freedom than a 529 plan in terms of investments; an ESA allows you to choose almost any kind of stocks, bonds, or even mutual funds, which you can’t do in a 529. You can also change investments anytime you want, whereas a 529 only allows you do change twice a year.
ESAs have relatively low contribution limits, allowing you to contribute just $2,000 per year per child, substantially lower than the $6,000 limit that a 529 plan allows. Also, there is a certain gross income that can regulate who can create one of these accounts. If your modified adjusted gross income is higher than $110,000 ($220,000 for joint income tax filers), you are not able to open an account. Finally, the money is an ESA must be used by the time the student turns 30; if funds aren’t used by age 30, the remaining amount will be paid out and taxed.
Roth IRAs
Most people think of the Roth IRA as a terrific method to save for retirement—which it is—but it can also be a great tool to help you cover education expenses. Unlike 529 plans, which can be used only to cover the costs associated with college, Roth IRAs can be used for both college expenses and retirement income.
In most circumstances, you incur a withdrawal penalty if you take funds out of your Roth IRA before age 59 ½. However, withdrawals are exempt from the penalty if the funds are used specifically for qualified educational expenses, like tuition, fees, books and room and board. you may withdraw funds early without penalty for college expenses or tuition. And, unlike a 529, a Roth IRA allows people who have funds leftover after withdrawing for college expenses to convert those dollars to retirement income – with no tax consequences or penalties. That means if you don’t use up all the Roth IRA funds to pay for your child’s education, you can use it to supplement your own retirement income.
Roth IRAs do have some drawbacks. If you are under the age of 50, you cannot contribute more than $6,000 each year. If you are older, you may add up to $7,000 to the account. Second, you need to have earnings in order to have a Roth IRA, making it difficult for retirees to open an account. Finally, those with high incomes cannot use this tool – for the 2020 tax year, your income must be under $139,000 (single) or $203,000 (married) in order to be able to contribute.
Brokerage Accounts
Brokerage accounts give you access to any investment type, whether stock, bond or mutual fund. Like a standard savings account, you can deposit and withdraw funds whenever you’d like without penalty (but you will pay taxes). Second, there are no contribution limits for a brokerage account; you can invest as much as you want. Third, you can withdraw the money any time for any reason, it doesn’t have to be education-related.
When it comes to brokerage accounts, the biggest disadvantage is the lack of tax benefits; 529 plans can be a better choice for some simply for this reason. It also is possible that there could be brokerage account fees or commission fees when making purchases or sales within your brokerage account.
There's No One-Size-Fits-All Answer
When it comes to college savings, it’s possible that a combination of these methods could be the best for you and your family. Your financial position, your beneficiaries, and your long-term goals all play a crucial role in how you save for education.
At the end of the day, paying for education requires forethought and careful planning. It is important that whichever method you choose, try to get started early in the child’s life, and make sure you fully understand your options. Consider meeting with a financial advisor to discuss your specific situation.
David Murdock, David Edelman and Randy Thiel are Registered Representatives offering securities and advisory services through Cetera Advisor Networks LLC, member FINRA/SIPC, a broker-dealer and a Registered Investment Advisor. Investments are: • Not FDIC/NCUSIF insured • May lose value • Not financial institution guaranteed • Not a deposit • Not insured by any federal government agency. Cetera is under separate ownership from any other named entity. For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice. All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
Investors should consider the investment objectives, risks, charges and expenses associated with municipal fund securities before investing. This information is found in the issuer's official statement and should be read carefully before investing.
Investors should also consider whether the investor's or beneficiary's home state offers any state tax or other benefits available only form that state's 529 Plan. Any state-based benefit should be one of many appropriately weighted factors in making an investment decision. The investor should consult their financial or tax advisor before investing in any state's 529 Plan.
Converting from a traditional IRA to a Roth IRA is a taxable event. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.
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