529s, Roth IRAs, And Runaway Tuition Costs: How Should We Be Saving For College?

by: Evan Powers

Summary

As college tuition costs continue to rise, planning for future educational costs has become difficult, since the financial need is hard to project.

While 529 accounts boast significant tax advantages, overfunding a 529 plan can limit a saver's flexibility if costs are lower than expected.

For those who are eligible, Roth IRAs can present an attractive alternative for college savings, since contributions can be withdrawn and used toward college costs.

Intelligently spreading contributions among the two types of accounts can allow for savings toward both educational and retirement goals, while minimizing the risk of overfunding.

Maximizing flexibility should always be the goal, and Roth IRAs can help provide that flexibility.

With last night's acrimonious final presidential debate now in the rearview mirror, this uniquely personal and caustic campaign cycle has now entered its final stretch into Election Day. Somewhere along the way, of course, the national conversation seemed to stray from the issues that defined the primaries, turning instead into a referendum on the personality traits (and defects) of the two major party candidates.

One topic that has fallen off the radar almost entirely (especially since Democratic contender Bernie Sanders suspended his campaign) is that of college education, and how best to address the ever-increasing costs of undergraduate tuition. Sure, the concept of student loan forgiveness is a central tenet of Green Party candidate Jill Stein's presidential platform (even if she doesn't exactly seem to understand how such forgiveness would work), but given that she's polling at about 2% nationally, the topic hasn't exactly surged back into the public consciousness.

So if "free college for everyone" doesn't appear to be on the immediate horizon, it seems like for the foreseeable future, we're still on our own when it comes to planning and saving for our kids' future college costs. And given that ever-increasing tuition costs continue to outpace the broader inflation rate, savvy planning can be of vital importance for those who wish to avoid condemning their children to a life of student debt slavery.

Unfortunately, the scope of the problem is so daunting that most people don't know where to begin. How much needs to be saved each year? Is a 529 a good idea? And could a Roth IRA help to assuage some of the inherent uncertainty that enters into the college savings equation? We'll try to sort through some of the most common questions and issues.

How much do I need to be saving?

From a consumer's perspective, the "purchase" (or investment in) a college education is one of the strangest and most difficult decisions we'll ever have to evaluate. Remember, choosing a college isn't like buying a car, or even a house -- you can't just do your research, assess the available options, decide which college best suits your needs and your budget, and then cut a check. You also need to first gain admission to the desired institution, which is of course easier at some institutions than at others.

Therefore, one of the largest purchases you'll ever make comes with an added complication of a necessarily limited set of potential options. How, then, can we be expected to save for an expense that is of an unknown (and unknowable) magnitude? After all, even if we knew the identity of the college in advance, we still wouldn't know the relevant tuition inflation rate over the next decade or more (yes, prepaid tuition programs can help remove that uncertainty, but they're not necessarily your best savings option).

Even before accounting for unknown inflation trends, the starting points for total cost of attendance can vary widely, from around $20,000 on average for a public college to $50,000 or more for a private institution. And over an 18-year time horizon (from a child's birth to his or her expected age of matriculation), the impact of inflation -- and of variations in the tuition inflation rate -- can be significant. The following chart shows how extreme the differences can be:

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That's a range of less than $35,000 per year on the low end to nearly $200,000 on the high end, a five-fold difference. Hence, an amount of savings that could cover an entire four years' worth of tuition in one potential scenario wouldn't even endow a single year in the worst-case scenario.

With that dramatic a level of uncertainty, how can a well-meaning parent best plan for the future? Assuming level annual contributions and a 5% investment return on college savings, here's how much would have to be set aside (each year for 18 years) in order to cover a full four years of costs in the previously cited situations:

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The raw numbers are, quite frankly, mindblowing (and remember, those numbers are per child; if you have multiple children, the numbers quickly veer into the realm of the unrealistic). But even if you do have the financial wherewithal to fully fund even the most aggressive savings scenario, what are the best vehicles to be using, and what are the consequences of overfunding your chosen savings vehicles?

How should I be saving?

Because of their various tax advantages (tax-free growth, availability of state income tax deductions in some areas), 529 plans have become the college savings vehicle of choice over the last decade. As the plans have grown in popularity, they have also steadily improved, to a point where most plan fees are now reasonable, investment options are generally ample, and even investor education has expanded.

For the vast majority of savers, 529 plans are indeed a better vehicle than other potential options (savings bonds, Coverdells, UTMA accounts, for example), but they're not without their drawbacks. Most importantly, the above-mentioned issue of overfunding is particularly problematic when the 529 is the savings account of choice.

If more funds are saved (or accumulated) in a 529 account then are needed for a given student, there aren't many options available for what to do with the remainder. Essentially, the options are to either transfer the account to another beneficiary (another child or perhaps a grandchild), to save for potential future educational costs for the same beneficiary, or else to withdraw the balance and pay a tax penalty on the earnings. In the last scenario (the "non-qualified distribution), the initial contributions won't be subject to tax, but any investment earnings will generally incur income tax (at ordinary income rates, not long-term capital gains rates) in addition to a 10% penalty (much like an early distribution from a tax-deferred retirement plan).

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Therefore, if a 529 plan is used, the balance of the plan will need to be carefully watched, lest the balance grow too large for the projected need. But given the wide range of potential projected financial needs mentioned earlier, it can be hard to know when enough is enough (or too much). That's where the Roth IRA could be a great alternative -- or additional -- option.

For those who are eligible to contribute to a Roth IRA, the particulars of a Roth can allow it to potentially serve "double duty" as both a college savings vehicle and a retirement savings vehicle. The Roth's flexibility stems from the ability to withdraw Roth contributions -- although not earnings -- at essentially any time, without penalty (note, though, that Roth funds stemming from conversions, rather than annual contributions, could be subject to a five-year waiting period before those contributions can be withdrawn without penalty).

Given the fact that 529 plans are fairly inflexible, but Roth IRAs offer significant flexibility (if you don't end up needing the Roth funds for college costs, you can still keep them in the account to save for retirement, whereas in a 529, there is no secondary use), we generally advise clients to take full advantage of any potential Roth IRA options before funding any 529 accounts.

For many savers, that choice may prove to be a false one: Most individuals or families who are in a stable enough financial position to be considering aggressive levels of college savings are likely also in a high enough tax bracket to make them ineligible to contribute to Roth IRAs (529s, on the other hand, have no such income limits). But in my experience as an advisor, I've encountered a non-trivial number of people who fall just under the relevant income thresholds, and who are therefore able to consider the relative merits of Roth savings versus 529 savings. Not surprisingly, we almost always encourage fully funding the Roth first, and only then turning to the 529.

Such an approach maximizes flexibility, while also minimizing the risk of overfunding the 529. As time passes and more information about projected tuition costs become available (either because we know more about our child's likely educational path, or because we learn more about inflation trends over time), we can always tweak our 529 contribution rates in order to "catch up", if necessary. A 529, once overfunded, is difficult to bring back in line, but catching up on the back end is essentially always an option, since annual contribution limits are high.

On a related note, it should probably go without saying that underfunding a 529 isn't nearly as large a problem as underfunding our retirement savings. After all, even if we never save a dime for college, student loans are still available, but for retirees, nobody has yet invented a retirement loan. Meet your retirement goals first, and then worry about college savings --that's all the more reason to embrace the Roth IRA.

Other considerations

Once the decision about optimal savings vehicles has been made, there can be secondary considerations that come into play. Certain strategies can help maximize a student's chances of receiving financial aid (but remember, if the rhetoric in this election cycle is any indication, making bets about the future direction of the FAFSA form is probably a fool's errand), and deciding what sort of an investment approach to implement in the chosen account type can also be an important consideration. How much investment risk is enough, or too much? And to what degree should a 529 investing strategy be integrated with an individual's other investment accounts?

In some circumstances, availability of certain tax credits can also be impacted, and deciding which sources of savings to tap first for college costs can present another puzzle for individuals and advisors alike. It's not necessarily the best approach to drain a 529 first, and then to look elsewhere; in some circumstances, it might be best to spread the 529 distributions out evenly over the four years of college, or to delay the 529 distributions as long as possible (without, of course, leaving too much left in the account upon graduation).

Regardless of the outcome of this election (and future elections), the college tuition landscape can be expected to change in significant, and possibly unpredictable, ways. Thoughtful planning in advance can ensure that tax-optimal strategies are implemented, without unnecessarily hampering flexibility over time. Whether your future tuition bill measures in the low five figures or well into the six-figure world, putting a plan in place today that's nimble enough to adjust to any future changes is bound to pay big dividends.

Just as an ideal retirement plan will often include both Roth IRA and Traditional IRA investments, the best college savings plan will balance the relative benefits of both a 529 plan and a Roth IRA, not to mention regular old taxable investment accounts. Don't put all your eggs in the 529 basket -- spread your bets among a variety of different savings vehicles, and you'll likely retain the flexibility to respond to a number of different future worlds. Hopefully, your children will thank you.

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