Hi, thank you for tuning in to today’s Emerald GEM, which stands for Get Educated in Minutes. I’m Cailin MacLean, advanced financial planning analyst for Wilmington Trust’s Emerald Family Office & Advisory and your host for today’s podcast. In today’s GEM, I’m going to answer the questions: What are some key considerations when choosing an education savings vehicle? How might I begin to decide which is right for my family?
There are a whole host of strategies available to us when it comes to paying for education expenses. Sometimes it feels like you need an advanced degree just to get a handle on what they are and how they work! And an appropriate plan for one student can differ widely for another, depending on factors like academics, family finances, donor priorities, and unforeseen circumstances. So, it’s understandable that many find this daunting. For parents and grandparents who may prioritize favorable tax treatment on the dollars they put toward their student’s education, using a general savings account, brokerage account, or trust might not be the best way to structure their education funding strategy. Today’s discussion will focus on laying out the key considerations for two savings vehicles that offer certain tax advantages when used correctly: 529 college savings plans and Roth IRAs.
First, how do they work? 529s and Roth IRAs are both funded with after-tax dollars, earnings in the accounts grow tax-free, and qualified distributions are tax-free. Now, what does qualified mean for each account? For 529s, this means many costs required for the enrollment or attendance at school (think tuition and fees, books, computers, and room and board). This definition was expanded by the 2017 Tax Cuts and Jobs Act to include up to $10,000 in yearly distributions for tuition at elementary or secondary public, private, or religious schools. One caveat is not all states have conformed to this expanded definition and consider K-12 tuition a non-qualified 529 plan expense. This would mean that the earnings portion of a non-qualified 529 distribution may be subject to state income taxes and recapture of the tax breaks connected to the distribution. Additionally, the 2019 SECURE Act allows for the distribution of up to $10,000 to pay for principal and or interest on qualified education loans. For distributions from a Roth IRA to be qualified, they must be taken at least five years after the account was established, and the owner of the account must be at least 59 ½ years old. Now, these rules apply to the earnings or investment income of the account, not the after-tax contributions you make each year which can be withdrawn penalty- and tax-free at any time, no matter your age.
What about withdrawals that aren’t made for education? Maybe the student joins the military, achieves full scholarships, or decides not to pursue college at all. Well, because 529 plans are designed specifically with education in mind, there are some financial consequences, like penalties and taxes, to be aware of if the assets are withdrawn and put toward something other than education. The good news is that the beneficiary of the account can be changed, just as long as the new beneficiary is related to the original beneficiary, and those penalties can be avoided. For example, if my eldest child ends up not needing the 529 account, the beneficiary can be changed to a sibling or cousin for their education without any negative consequences. Additionally, in the case of the student receiving a scholarship or pursuing military ROTC, non-qualified withdrawals up to the amount of the scholarship can be taken out without penalty, but any earnings included in that withdrawal will be subject to income tax. Meanwhile, Roth IRAs, typically used as a retirement account, can be put toward anything and would not incur any penalties or taxes—just as long as the five-year period and age requirements have been met for withdrawal of earnings, as mentioned earlier.
Now, let’s compare each accounts’ contribution limits. You can contribute up to $16,000 per year (or up to $32,000 for a married couple), per 529 account, without using your lifetime gift exemption. You can also “superfund” the account by contributing up to $80,000 (or up to $160,000 for a married couple) in one year. Just be sure to then elect to treat that contribution as having been made over a five-calendar-year period for tax purposes on your gift tax return form 709. There are no income limits for contributors. For Roth IRAs, you’re limited to a maximum annual contribution of $6,000 if you are below the age of 50 ($7,000 if you’re above) and the account is subject to income limits. To contribute these maximum amounts in 2022, income for single filers must be less than $129,000 or less than $204,000 for those married and filing jointly.
What about investment performance? Put simply, Roth IRAs may give you, as the account owner, more freedom when it comes to investment selection. With 529s, you’re limited to a set menu of choices depending on which state’s plan you choose, and you may reallocate the asset mix of the account no more than two times per year.
Now that we’ve covered the basics, let’s discuss two ways you might approach the decision of which account makes the most sense for you and your family. One of the first questions you should consider is whether your state offers a tax benefit for contributing to a 529. Some states, like New York, offer tax deductions or credits on contributions made by residents to their own state plan, while other states, like Pennsylvania, offer tax benefits to residents for contributions made to any state’s 529 plan. Please consult your tax advisor for what this may look like in your state of residence. Roth IRA contributions, on the other hand, are not deductible.
Second, how might need-based financial aid be impacted by either account? The free application for federal student aid, also known as FAFSA, is how the federal government calculates how much need-based aid a student is eligible to receive, and how much the student’s family is expected to contribute toward paying for college. Every school requires you to complete the FAFSA to receive federal need-based aid. Things like annual income, bank and brokerage accounts, and the value of vacation homes are factored into the FAFSA equation, while things like life insurance, retirement plans, and the value of a primary residence are not.
A 529 account may impact the FAFSA in two ways: by the account value counting as an “asset” and by distributions from the account counting as “income.” The degree to which the account is considered in the equation comes down to ownership. A 529 that is owned by a parent or student is counted when determining financial aid eligibility. Those held in the student’s name count for more than those owned by parents. Qualified distributions from a parent- or student-owned 529 do not count as income for expected family contribution purposes. However, when the 529 account is owned by someone other than the student or parent, such as grandparents, financial aid eligibility could be jeopardized. In this case, the distribution would be counted as untaxed income to the student on the FAFSA, resulting in reduced need-based financial aid awarded. To minimize the impact, timing the distribution from a grandparent-owned 529 becomes very important. In fact, because there is roughly a two-year lag in income data for the FAFSA, delaying distributions from the grandparent-owned account until the student’s junior year of college may be a way to avoid this pitfall.
Roth IRA assets, as well as other qualified retirement accounts, such as traditional IRAs or 401(k)s, are not counted at all in determining the expected family contribution. However, if you use money from a Roth IRA to pay for college, making that distribution will affect your expected family contribution two years after you do so, for the same reason as the grandparent-owned 529 account: the entire withdrawal will eventually show up as income on the FAFSA form, even the tax-free growth, which shows up as untaxed income. Therefore, like the 529 plan, the timing of the distribution from a Roth IRA is crucial. It’s important to note that while retirement accounts are not counted on the FAFSA, they are considered on the CSS Profile, an additional aid application not required by every college. The best way to figure out if both the FAFSA and CSS are required by a school is to speak directly to the school’s financial aid office.
Like any financial goal or decision, planning is key to achieving the optimal outcome. There’s no one-size fits all course of action. The strategies discussed today may work for some, but there are other strategies not mentioned that may be better suited for you, depending on your priorities. Figuring out what matters most to you can be a great starting point. Is it maximizing annual contributions, or minimizing your estate? Is it receiving tax benefits? These proactive actions, when also considering the current and projected costs of college, can help set a strategy that is best for your family.
Thanks again for joining us today. Please contact your Wilmington Trust advisor if you have any questions about savings vehicles for your family’s education expenses. We would be glad to help you. See you next time!