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Today, we're talking about college savings and specifically what account you should use if you're planning to save for college. And I think the correct approach here is not as obvious as it may seem. So let's jump in.
Before we get into the accounts, I want to set the stage with why this is important.
This is not going to be a shock to anybody, but college is expensive. You have tuition, room and board, books, and that's all on top of the normal living expenses.
The average sticker price for college, according to a report from the College Board, is $60,420 for private schools and $28,840 for public schools.
That's sticker price, and this is really important because the sticker price is the price that you're going to see everywhere, but a lot of people actually don't pay the sticker price because of financial aid.
When I say financial aid, I'm not talking about loans, but things like scholarships and grants. Those can lower the cost of college significantly.
The price we want to look at is called the net price. The net price is what people actually pay.
And in the same report, they found that the average net price for private schools was $34,790. And for public schools, it was $20,310. So on average, we can expect four years of college to range anywhere from $80,000 to $140,000 or more.
Schools are going to have a net cost calculator on their website, which will allow you to put in details like grades, test scores, and financial information, and then see what the net cost to go to that school would be.
And before you rule out any schools because of cost, I would encourage you to use these net cost calculators because the actual cost may be a lot lower than you think, especially for private schools, which tend to hand out more financial aid.
With that aside, let's jump into the account options for saving for college. The three accounts we're going to talk through today, which I think are the best options, are the 529 college savings plan, the Roth IRA, and the taxable brokerage account. Let's go over 529 plans first.
529 plans are specifically made for college savings. And how they work is you contribute money into the 529 plan, and then you invest those dollars in one of the options that they have available.
There's typically going to be investment options based on the date that your child would be enrolling in school. And so those options can be a simple way to get a diversified allocation invested for the right time horizon.
Hopefully your investment grows from the time that you contributed the money to when you actually need it to pay for college. And as long as you use that money in the 529 plan for qualified education expenses, then everything comes out tax free.
“Qualified education expenses” are pretty broad. They can be things like tuition books, but also things like a laptop if it's used for school.
Every state has their own 529 plan, but you don't have to contribute to your state's plan. Also, you can use a 529 plan from one state to pay for college expenses in a different state. So they aren't limited in that way either.
The advantages of 529 plans are, first and foremost, the tax free growth, which we already touched on. And this is definitely the biggest advantage of a 529 plan.
Also, while there's no federal income tax deduction for 529 contributions, some states do offer a state income tax deduction.
One important thing to note with that though, is that some of the states that do offer this deduction will require you to contribute to their state's 529 plan in order to get that income tax deduction. So ultimately, you want to check with your state's specific rules around this to see if this is a benefit for you.
Funds in a 529 plan can also be used for K-12 school tuition as well. So if your child is going to a private school, this is an important thing to keep in mind.
Lastly, 529 plans are treated as a parental asset on the FAFSA. And the FAFSA is the application for financial aid that you fill out each year. And parental assets are treated more favorably in terms of securing as much aid as you can compared to student assets. And so it's a good thing that 529 plans are treated as a parental asset, even though they're technically in the child's name.
Let's move on to the big disadvantage of 529 plans, which is flexibility.
If you withdraw money from one of these accounts for anything other than qualified education expenses, you're going to be taxed on your earnings and you'll get a 10% penalty on top of that.
There's a lot of uncertainty around future college expenses, particularly when your child is young. And so this is a pretty big disadvantage.
For me, my oldest is still a decade from college, so I don't know if she'll go to college. And if she does, will she get scholarships or will the cost be a lot different than it is today?
These are big unknowns. And so to commit a bunch of money for this sole purpose may not be a wise choice.
There are some exceptions or workarounds to this that I want to mention.
First, if your child does get a scholarship, you can withdraw an amount from your 529 equal to that scholarship penalty-free. You're still going to get taxed on the earnings, which is not ideal, but you won't have to pay a penalty on top of that.
Also, you can change the beneficiaries of a 529 plan any time you want. So if you have a 529 plan in the name of a child who doesn't go to college, you could change the beneficiary to one of your other kids who does go. Or you could eventually change the beneficiary to a grandchild and then give that money a lot of time to grow. So this can be a good way to avoid penalties and taxes if you have too much money saved in a 529 account.
One other exception is new legislation that says you can roll some of your unused 529 money into a Roth IRA. There's a lot of restrictions here on what's allowed, so I wouldn't contribute to a 529 plan with the expectation of rolling it into a Roth IRA, but it's good to know that the option may be there.
Roth IRAs are normally a retirement account, but they can be used for college savings as well. And I'm going to tell you how, but first I want to cover how a Roth normally works.
With a Roth IRA, you contribute money after tax, meaning you don't get any tax deduction for your contributions. But then after you turn 59.5, you can start withdrawing money from a Roth completely tax-free. So it works like a 529 plan in that way, except of course it's for retirement.
There are contribution limits to Roth IRAs, and there are also income limits. So if your income is over a certain amount, the IRS won't allow you to contribute directly to a Roth IRA.
Even if you're over those limits though, you can still use a backdoor Roth IRA strategy to still get money in a Roth IRA. And I'm not going to go over the details on how to do that in this video, but just know if you want to contribute to a Roth IRA, there's often a way to do it.
How do you use a Roth IRA to pay for college? The key thing to know with Roths is that you can withdraw your contributions from a Roth IRA at any point tax and penalty-free. You just can't dip into the earnings.
Well, if you're putting money away in a Roth for a long time, you're going to have a lot of contributions, which means you're going to have a lot of money that's accessible to withdraw for college, tax and penalty-free.
Let's say you and your spouse max out Roth IRA contributions every year from the time your child is born until they turn 21. Using the $7,000 max in 2024, that's $147,000 in contributions per person over those 21 years for a total of $294,000. That's a lot of money to help with college expenses.
The major advantage of Roth IRAs is that they're much more flexible. If your kid doesn't go to college, then you have that money saved for your retirement.
There are a few disadvantages of using a Roth IRA.
Number one, your contribution limits are relatively low. So you can get a lot of money in a 529 plan, but with a Roth IRA, as I already mentioned, you’re limited to $7,000 per year per person in 2024. And if you want that to cover your retirement and your child's college, that's going to be tough.
The other disadvantage, which we touched on, is that you can't use the earnings from your Roth IRA for college without taxes and penalties, unless you're over the age of 59.5.
Lastly, while the balance of a Roth IRA is not counted at all on the FAFSA, withdrawals are counted as income. And so it could impact your child's need-based financial aid.
The income used on the FAFSA is the income from two years prior, meaning if you had withdrawals from a Roth in your child's freshman year, it wouldn't actually impact their financial aid until their junior year. And withdrawals taken after January 1st of their sophomore year won't impact financial aid at all if they graduate in four years.
We've gone over 529s and Roth IRAs. Let's touch on the last one, which is taxable brokerage accounts.
These are just regular investment accounts. You put money in, you invest it in whatever you want, and then when you sell any of those investments for a gain, you're going to pay taxes. Also, if those investments pay dividends, you'll get taxed on that as well. Now, you may pay less in taxes on some of your gains if you've held the investment for more than a year, but the tax advantages here are minimal.
However, the big advantage is the flexibility. There are no restrictions on when or what you use this money for. If you want to use it for college, great. If you're going to save it for retirement, that's fine as well.
Besides the minimal tax advantages, the other downside to a brokerage account is its treatment on the FAFSA. If the account is in the parent's name, it's just treated as a parental asset just like the 529. However, dividends and capital gains are also treated as income.
If the account is in the name of the child, it's going to negatively impact your financial aid even more because it's going to be treated as a student asset.
Alright, so we can summarize the three account options on the dimensions of tax advantages, FAFSA treatment, and flexibility.
A 529 is going to have the best tax treatment, some FAFSA impact, and the least flexibility.
A Roth IRA will have a lot of tax advantages as well, and also some potential FAFSA impact, but more flexibility than the 529.
The taxable account has minimal tax advantages, the worst FAFSA impact are the three, but also the most flexibility.
So how should you proceed with college savings knowing all of this? Well, to me, the central tension is the unknown. We don't know if we'll need to pay for college, and if we do, how much it's going to cost. And the further you are away, the more uncertainty there is.
If we knew for certain our kids were going to go to college, and we knew what our responsibility for that bill would be, then a 529 plan would be the best place to save for it, no doubt.
However, because of the uncertainty, a Roth IRA becomes a more valuable tool, in my opinion. It gives you the opportunity to save a lot, but also the flexibility to use it elsewhere if your child opts out of college, or the cost ends up being less than you thought.
So in general, my approach to college savings is to max out Roth IRA contributions (or backdoor Roth contributions if your income is too high) before you contribute anything to a 529 plan. If you're maxing Roth contributions already, and you have more money available to save for college, then go to a 529 plan from there.
By doing it this way, you're prioritizing the more flexible account if your ability to save is limited. If it gets time to pay for college, and you have the means to do so, then you can utilize your Roth IRA and help out with costs.
If your ability to save is beyond maxing out your Roth IRAs, then great, use the Roth IRAs for retirement, and use the 529 plan for college.
This is general advice, but everybody's situation is slightly different. So make sure you talk with a financial professional before making any changes to your financial plan. If you don’t have a financial professional to consult with, reach out to us by scheduling a free consultation below.
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