Saving for college in America: 529 vs Roth IRA

[englishteacheralex]

I'll keep this short and sweet.

We have a 529 plan for our two kids, aged 4 and 2. We live in a state that provides no tax benefit for a 529. We have about $18k in the 529 plan.

It seemed to us that a Roth IRA is pretty much the same thing as a 529, with the advantage that with a Roth IRA, the money doesn't have to be used for college. So we now dump our kids' college savings into my Roth IRA, since we are under the impression that you can withdraw Roth IRA money for qualified educational expenses.

Questions:
1. Is there some advantage to the 529 that we're missing?

2. Is there a reason we should open two 529s--one per kid? Our understanding is that the 529 can be used for qualified educational expenses for any member of the family, so what's the point of having more than one?

3. Is there a disadvantage to using my Roth IRA that we're missing? We can't afford to max out one for me and one for my husband, so that's not a problem for us.

[Buffaloski Boris]

529 plans are great in the states where contributions are deductible or can be used for a tax credit.  As of last year they can also be used for K-12 private school tuition for I think up to $10K per year.  If a state doesn't have a state income tax or doesn't allow contributions to be deducted, then they lose a lot of their attractiveness in my opinion. In that case, they would be the sort of investment I would personally fund toward the end of the list, if at all.

One nice thing about 529s is people are not stuck with their state's plan. If it's nondeductible anyways, might as well pick the best state plan. As always, YMMV.   
 

[secondcor521]

I'll keep this short and sweet.

We have a 529 plan for our two kids, aged 4 and 2. We live in a state that provides no tax benefit for a 529. We have about $18k in the 529 plan.

It seemed to us that a Roth IRA is pretty much the same thing as a 529, with the advantage that with a Roth IRA, the money doesn't have to be used for college. So we now dump our kids' college savings into my Roth IRA, since we are under the impression that you can withdraw Roth IRA money for qualified educational expenses.

Questions:
1. Is there some advantage to the 529 that we're missing?

2. Is there a reason we should open two 529s--one per kid? Our understanding is that the 529 can be used for qualified educational expenses for any member of the family, so what's the point of having more than one?

3. Is there a disadvantage to using my Roth IRA that we're missing? We can't afford to max out one for me and one for my husband, so that's not a problem for us.

1.  Nope.  As noted, the biggest draw is a state income tax deduction or credit.  Most states have one, but only for state taxpayers.  If yours doesn't, then, as a previous poster noted, that makes them less attractive.  A few other minor benefits are (1) sometimes states will allow employers to set up automatic payroll deductions into 529s, (2) There are usually low minimums to open a new account, and (3) not applicable to you at the moment, but a 529 usually has a higher annual contribution limit.

2.  Yes, there is.  Your statement is approximately accurate but technically wrong - and the IRS cares about technicalities.  529 distributions can only be used to pay for qualified educational expenses for the named beneficiary on the account; otherwise the distribution is taxable.  So if you had one 529 for your older child and used money from that 529 to pay for expenses for your younger child, then that distribution would be taxable and possibly even penalized 10%.  It is easy to get around this.  Either (a) open two different 529s, one for each kid, and/or (2) transfer money between the two 529s.

3.  If you might qualify for financial aid, there is a secondary effect.  While the withdrawal from your Roth IRA to pay for college expenses is tax free and doesn't affect that year, the withdrawal should be reported as tax free income on the following year's FAFSA application, and would, on average, reduce the amount of aid offered the next year.  If this results in a larger Roth IRA withdrawal in year 2, then this would have a snowball effect.  There are a few other disadvantages listed here:  http://www.finaid.org/savings/retirementplans.phtml

[seattlecyclone]

It seemed to us that a Roth IRA is pretty much the same thing as a 529, with the advantage that with a Roth IRA, the money doesn't have to be used for college. So we now dump our kids' college savings into my Roth IRA, since we are under the impression that you can withdraw Roth IRA money for qualified educational expenses.

Eh, kind of. Educational expenses do exempt you from paying the 10% early withdrawal tax on any withdrawals where that tax would otherwise apply (i.e. withdrawals of conversions that are less than five years old, and withdrawals of earnings). However if you dip into the earnings bucket of your Roth IRA you'll still be paying tax at your regular marginal rate for these withdrawals. Educational expenses don't get you out of this tax.

By contrast, the 529 lets you spend the whole sum (contributions plus earnings) on educational expenses without owing any tax.

I'd say that you should probably focus on your IRA contributions for the time being. You already have a pretty solid balance in your 529 given the ages of your kids, and prioritizing Roth IRA contributions should give you more flexibility to decide between spending this money on education or your own retirement expenses when the time comes.

[Paul der Krake]

I-bonds are doubly great for Hawaii because the state taxes are brutal and I-bonds are exempt from state taxes (and federal if used for education). The downside is that nobody is getting rich from I-bonds.

Roth IRA space is very limited and precious. I think using it for college tuition is, in most cases, a mistake.

You already have a good chunk saved in the 529. If I were you I'd prioritize your own retirement and let the 529 do its thing, adding only to it when you can.

[sol]

There are different kinds of tax savings.  If you don't get a state tax deduction for your 529, then you are funding either the 529 or the Roth with after-tax money.  In both accounts the money grows tax free each year, and in both accounts the contributions can be withdrawn for qualified educational expenses without tax or penalty.  So they look pretty identical to me.

Except that many mustachians are maxing out the contribution limits on Roth IRAs, in which case the 529 looks an awful lot like a "bonus" Roth IRA for people who will be contributing to college expenses anyway.  I wouldn't fund the 529 before filling the Roth, but I would definitely contribute to it after filling the Roth.  That second and third type of tax savings are still real and make the 529 a better investment than a regular taxable investment account, which is where many of us end up putting our additional savings.

[englishteacheralex]

Wow, lots to think about. As usual, the MMM forumites hand out valuable information like candy at a parade. Thanks, everyone, for taking some time to respond. I just read all the posts out loud to my husband.

[Car Jack]

You can hit an income limit with savings bond redemptions for education.  But they're always state tax free, no matter what you use them for.

With a Roth, you have full choice of what you're going to do with the money.  If you can cash flow college or scholarships appear or the grandparents chip in way more than expected (happened for our kids), then Roth money is still there come retirement time.  If you don't use those 529 dollars for college expenses, then you'll be paying penalties.

Just to mention a loop hole......for grandparents who are up in arms about having to report gifts over $15k......a grandparent can pay college expenses directly (check to the bursar's office) for any amount and this does not count towards gifts.  Both my mom and my father in law are very much in this "I'm not telling the government who I'm giving money to....get off my lawn" mode and both were extremely happy to hear about this loop hole.  Both have contributed to my son's college bills because of this loop hole.

[secondcor521]

With a Roth, you have full choice of what you're going to do with the money.  If you can cash flow college or scholarships appear or the grandparents chip in way more than expected (happened for our kids), then Roth money is still there come retirement time.  If you don't use those 529 dollars for college expenses, then you'll be paying penalties.

There are no penalties for withdrawals from 529s that are not used for college expenses to the extent that the student receives scholarships.  The withdrawer will pay ordinary income tax (but not SS/Medicare taxes) only on the earnings portion of the withdrawal.  If the withdrawer is the student, this might be done fall of senior year when the student is in a relatively low income tax bracket.

Also, for those with multiple children, or nieces/nephews/grandchildren they like, 529's can be transferred to them.

In my situation, I have three kids.  As their college plans have solidified, it looks like I'll have some left over in their 529's, but the amounts are less than the scholarships each of them have received or will receive.  So my general plan will be to transfer the 529's to them in the fall of their senior year, have them withdraw the balance, and they'll pay no penalty, and report ordinary income only on the earnings portion.  They can then use that money to start out their post-college life (apartment down payments, plane tickets to their new job location, living expenses while job-hunting, etc.).  Some of my kids might even max out their Roth IRA contribution that first post-college year.

[letsdoit]

we were advised to create  a trust , as opposed to a 529