IRA – College 529 Savings Alternative
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Every parent desires their kids to have a better life than themselves. Every parent desires for their kids to go to college, get a degree, pursue their dream career, and lead a good life. The best time to start saving for college education is when the child is born, to leverage the power of compounding.
It takes time for compounding to have a significant effect – so the sooner you start the better. Okay, now the question is – where do you put the money? What are my choices? The most direct and obvious choice is a college 529 savings plan.
While a 529 college savings plan is still a very good instrument to save for college, it comes with its set of pros and cons. Is there a viable alternative? Yes, there is!
In this post, I highlight IRA (Traditional or Roth) as a viable alternative.
An Important Note and Assumptions
The first and foremost priority for parents is to ensure that you are contributing to your retirement savings plan (like 401k) and that you taken the adequate steps to ensure that you would have enough money saved for retirement.
From a priority perspective, saving for kid’s college education comes next. Remember, you can borrow to go college, you can’t borrow money for your retirement.
My assumption is that you have done the due diligence to ensure that you have a proper retirement savings in place that is not dependent on your IRA.
If that is the case, then an IRA could be used as an alternate investment / savings for kids college education.
Challenge for a new parent
You have a new born child, and you know the right thing to do is to start saving money for college education. How do you know how much you should save for college 18 years from now? A million things can change over an 18 year period. The cost of education is a huge variable depending on the choices made by your son or daughter – whether they to go in state, out of state, or a private university, whether they receive grants or scholarships – the list of unknowns is long…
The main drawback with a College 529 Savings Plan is that all the money you put into it must be used for qualified educational expenses. If the money is pulled out for any other purpose, the capital gains are taxed, and in addition you get hit with a 10% tax penalty.
The best thing you can possibly do is to eye ball the estimate and use that magic number as the target goal and start putting money away into a 529 college savings plan.
For the purpose of this post, I am going to neutralize and say that the investment performance in an IRA and 529 college savings plan are the same. As it stands today if you start putting away $5500 per year, and it grows at the rate of 8%, it will grow to a total of $205,976.34 over an eighteen year period. That is a good chunk of money!
Excel Future Value Calculation Explained:
You can do this calculation yourself in Excel. If you type “=FV(0.08,18,-5500)”, in an Excel cell, you will get the result $205,976.34.
If you want to understand how the above calculation works, please read my post on time value of money.
Annual Growth rate = 8% (0.08 – first parameter)
Period = 18 years (to keep it simple, compounding is done annually)
Payment = $5500.00 (sign is negative because it is the out of pocket contribution made to the IRA).
Traditional IRA – an alternative to 529 College Savings Plan
An IRA comes in as a good alternative to a 529 College Savings Plan. According to IRS (Education Exception to Additional Tax on Early IRA Distributions), you could withdraw from an IRA for educational expenses penalty free. Extract from the IRS page: “Generally, if the taxable part of the distribution is less than or equal to the adjusted qualified education expenses (AQEE), none of the distribution is subject to the additional tax. If the taxable part of the distribution is more than the AQEE, only the excess is subject to the additional tax.”
#1 You could start a traditional IRA and dedicate it towards your child’s college education at a brokerage firm of your choice. If you are a DIY type investor, this would make perfect sense for you. The main thing to note is that there are lot of investment choices unlike a 529 college savings plan.
#2 If you want to automate the investments using a robo-advisor, then you could invest in an IRA through Wealthfront or Betterment. Both of them make investment seamless. If you would like learn more on how robo-advisors work, you can read my Betterment Review and Wealthfront Review here.
#3 Based on your income level, your contribution towards your traditional IRA might be deductible. Check the IRS page if you qualify for deductions. Yes, you might be able to deduct it and pay less in taxes.
#4 You can withdraw the required amount of money from an IRA for college education when the time comes. If there is money left over in the IRA after the educational expenses have been paid for, you can withdraw it at retirement at your regular tax rate without any penalties.
Fidelity has an awesome comparison chart of 529 college savings plan vs. retirement savings account.
Chart Source / Courtesy: Fidelity.com
Technically, sticking to the letter of the law, 529 college savings plan is still the best primary choice, if you used all the money saved up under the plan for education.
You could transfer the fund to a sibling, your grandchild, or yourself, but it must always be used for education – if it needs to be pulled out for any other reason, you end up paying taxes and a 10% penalty.
Therefore a hybrid approach may be suitable where in you could have a portion saved up into 529 and the remaining portion invested in an IRA which would give you some flexibility.
If you understand the big picture, and would like to use an IRA as a back up or alternate strategy to fund your kids college education, and are not sure of how to go about it, consult a fee-only financial advisor and get an IRA set up that is targeted towards college savings.