College costs went through the roof years ago, and they’ll probably be past the moon by the time your kids are ready to attend. Read on for the most important piece of advice regarding college savings, as well as a comparison of two popular ways to save: IRAs and 529 plans.
The Most Important Piece of Advice
Start saving now. Don’t have kids yet? Even better, start anyway.
One of the biggest mistakes parents make regarding college savings is starting too late or not at all. Saving for education might seem like a lot to manage when you’re already stressing about retirement and paying for a house. However, even if you can only set aside a couple hundred dollars every few months, the earlier you start, the more time your money has to grow.
Traditional IRAs and Roth IRAs
Traditional IRAs and Roth IRAs are usually used to save for retirement; however, they can also be used to save for college. Typically, there’s a penalty of an additional 10 percent tax on distributions from a Traditional IRA or Roth IRA if taken prior to age 59 ½, unless the entire distribution is used to pay qualified educational expenses for yourself, your spouse, or a child. In this case, the 10 percent penalty tax can be avoided and you’ll only pay the usual income tax for your IRA.
With a Roth IRA, you can withdraw your contributions at any time, tax free. For example, if you contributed $3,000 each year for four years, you could withdraw $12,000 to spend on education with no tax consequences. Your earnings would remain in the account and continue to grow.
The main draw of using an IRA to fund college expenses is the flexibility: if college expenses are lower than expected or your child chooses not to go to college, you can put the money toward your retirement without any adverse tax effects. However, this flexibility is also the main drawback to using an IRA as a college savings account: you’re splitting up a retirement fund. You can only contribute so much each year to an IRA. Therefore, if you use some of that money to pay for educational expenses, you may have issues achieving your retirement goals.
529 plans are state-sponsored accounts that allow you to invest for the purpose of higher education. Earnings in a 529 plan (withdrawn to pay for qualified educational expenses) are exempt from federal tax and generally exempt from state tax. You can open as many 529 plans as you need and contribute as much as you like as long as the balance does not exceed “the amount necessary to provide for the qualified education expenses of the beneficiary.” This amount varies by state.
529 plans are available in every state, with varying rules and benefits. However, before you go looking elsewhere, check the incentives in your state. There may be favorable tax treatments or other benefits to investing locally that you’ll lose if you cross state lines with your child’s college fund.
The drawback to a 529 plan is that you can’t withdraw earnings for anything other than qualified educational expenses without incurring a hefty 10 percent penalty tax. If you saved a lot more than your kid needs, that will be a tough pill to swallow when you go to withdraw the remaining earnings.
A Note on Savings Bonds
In the past, savings bonds were a very popular way to save for college expenses. In certain (complex) situations, the interest on savings bonds will be tax free if the proceeds are used for qualified educational expenses. However, there’s a fair amount of red tape, and with such low interest rates these days, ,, ait often isn’t worth it. You should still keep an eye on it though—when it’s time to help out your grandkids, interest rates may be on the rise again.