[Editor's Note: Johanna Fox Turner, CPA, CFP, RLP, is a fee-only financial advisor who sent me a guest post. While I liked some of the ideas in it, I disagreed with others so I offered to run it as part of the always-popular Pro/Con series. Johanna advertises on the site and serves as a moderator on the forums.]
PRO – Johanna Turner
An alternative approach to saving for college
While many parents consider 529 plans the default choice when it comes to college savings, they are not a one-size-fits-all solution. You should carefully consider the reasons a 529 may or may not be appropriate, such as:
- New competitors may force the cost of college to decline and you may not need $200k – $300k to educate today’s toddlers. We’re already seeing such a trend in online programs along with the rise in popularity of community colleges and vocational schools.
- Navigating the various 529 options is difficult and investment plans are mostly inflexible.
- Your child may choose not to go to college, may get a scholarship, or may go into a loan forgiveness program.
- You could owe both tax and penalties on growth and earnings not used for college.
If you’re hesitant about building a huge 529 account for your children, consider this alternative plan: earmark your Roth IRA as the primary college savings account, supplement with a Coverdell ESA (Education Savings Account) and then put additional savings in a 529 or taxable investment account. Why does your Roth make sense?
- Many new parents cannot fully fund a Roth IRA, max out 401k(s), and contribute to a 529 and/or Coverdell ESA (Education Savings Account). They may choose to sacrifice retirement savings in favor of college funding.
- You and your spouse can contribute $11,000 annually or $198,000 over 18 years.
- You get 3-way access to a Roth:
- Original contributions can be withdrawn and used for college at any time with no tax or penalty (no 5-year rule),
- The earnings on original contributions can be withdrawn tax- and penalty-free after as little as 3 years and 8.5 months, and
- The principle of Roth conversions can be distributed penalty-free after a 5-year waiting period.
- You are free to invest in a well-diversified equity mutual fund or ETF portfolio according to your investing philosophy (not limited to 529 portfolio choices).
- Even if you need 100% of original contributions for college, you still have the growth in your Roth.
- You’re not penalized if you don’t use your Roth for college. You get to keep your money and continue building for retirement.
- Your Roth’s earning can be used for college expenses without penalty, although you will pay taxes if you’re under age 59.5. (I recommend leaving the growth and earnings alone.)
- Roth IRAs do not count against you for financial aid, unlike 529s and ESAs. Do some physicians get financial aid? You bet they do, especially in today’s environment.
To add a cushion to your Roth, next max out an ESA ($2k per child per year). If your income bracket is too high to contribute, you can gift the money to your child to contribute. ESA benefits:
- Availability – you can tap the ESA as soon as your child starts kindergarten.
- Flexibility – you can invest any way you want,
- Use of money – your ESA can be used for a wider variety of costs than can the proceeds of a 529 plan, including home computers and transportation.
Finally, if you want to save even more for college, then contribute to a 529. I call these “grandparent” accounts because 529s are great use for money from grandparents, aunts, uncles, godparents, etc. Of course, if your state gives you a tax credit or deduction for contributing to a 529 plan, you’ll want to weigh the benefit compared to the quality of the plan. For example, Pennsylvania allows residents a $14k per contributor per beneficiary to any state plan, or up to $860 in tax savings annually on a joint return. (Even then, you should consider whether the tax savings would outweigh long-term returns for a properly invested and managed portfolio.)
Of course, saving for college in a taxable account is also an option. You’ll enjoy most of the benefits of saving in a Roth IRA except the balance will count for FAFSA. You’ll pay tax on growth and dividends at a maximum rate of 20% (today’s rates) but you also may push your income into the Medicare penalty tax bracket and/or AMT.
OK, so it wouldn’t be fair if I didn’t review the disadvantages of tagging your Roth for education savings:
- If you use it for college, you won’t have as much saved for retirement.
- You may not qualify to contribute to a Roth IRA due to income limitations. You can contribute to a Backdoor Roth IRA but it won’t be beneficial if you own pre-tax IRAs.
- You may be horrible at investing, which can easily be remedied with the help of WCI and/or a fee-only financial advisor.
It’s hard to predict how much you’ll need to save, and the best method, for an event that is almost two decades into the future. Unlike retirement, however, there are loans, scholarships, and other options to fund a college education. Fortunately, you have WCI here to help you narrow down your choices and make the best decision possible for your specific situation.
CON – WCI
529 Plans Are The Best Way To Save For College For High Income Professionals
My esteemed opponent has given a lot of great ideas to pay for college, unless you're a doctor, in which case most of them either don't work or are a bad idea. Not so bad as buying a whole life insurance policy to pay for college, but still a less than optimal solution.
Since When Are 529s Bad?
Ms. Turner suggests a few reasons why 529s might be less than ideal. I'd like to look at these one by one. First, she suggests that the cost of college may come down. While I agree that value should be an important factor when choosing a college, and I am a big supporter of both state schools and community colleges (especially for the first two years,) I am highly skeptical that the average price of a college education is ever going to be lower than it is right now. Besides, that really has nothing to do with how you save for college unless she is suggesting that saving only $2K a year (the Coverdell ESA contribution limit) is somehow going to be enough.
Next, she suggests that it is tough to choose a 529. I disagree. It is really a simple process. First, look at your own state 529 website and see if you get a tax break for using it. If you do, put enough into it to max out that tax break, then use a highly rated plan such as Utah, Nevada, or New York for the rest of your savings. If your state offers no benefit, then just go straight on over to the UT, NV, or NY plan. Easy-peasy.
Then she suggests that 529 plans are inflexible. I disagree. Let's take a look at the Utah plan. There are 23 different funds, all excellent from Vanguard or DFA that you can combine in just about any way you like. In addition, there are four “Global Allocations” from DFA, 8 static allocations, and four age-based options. You can change those around frequently (although I don't know why you would want to) and can even change to a different 529 all together once a year. You can spend the money on any qualified education expense. I'm not sure what kind of flexibility Ms. Turner is looking for, but there is more than enough there for my needs. In fact, I wish I could get some of those funds in my Roth IRA at Vanguard!
Next, she suggests that a downside of 529s occurs if your child doesn't go to college, gets a scholarship, or goes into a loan forgiveness program. Yes, there are rules you need to follow if you want the tax-free growth that 529s offer. But most of these issues are addressed by the 529 laws quite well. If your child doesn't go to college, you can use the 529 to pay for the education of your other children, grandchildren, extended family members, or even yourself without penalty or taxes. If the child gets a scholarship, you can take an equivalent amount of money out of the 529 penalty-free (but not tax-free.) And why would I want my kid to have student loans to be forgiven? Isn't that the point of saving for college in the first place? I mean, is that really an argument not to save for college in a 529 just in case someone offers them loan forgiveness later? An ESA, which Ms. Turner is okay with, has basically the same rules and penalties anyway.
Burn Your Valuable Roth on College?
A major portion of Ms. Turner's recommendation is to use Roth IRA money for college. Roth rules state that you can withdraw Roth IRA money tax and penalty-free if used for qualified educational expenses. So it is obviously legal to do so. But that doesn't make it smart, especially for a high income earner. Once you pull that money out, it can't go back in. Roth IRA space is so incredibly valuable for a high-income professional and his family that it shouldn't be wasted on a college education, as valuable as that might be. If you start contributing to a Roth IRA at 30 as a resident, it might enjoy tax-free growth for the next 60 years until you die. Then, as a stretch Roth IRA, it might grow for another 50-100 years tax-free. By spending it after just 10-20 years, you're losing out on over a century of tax-free growth. Seems kind of dumb when you look at it like that, no?
In addition, most high-income professionals (at least those interested in seriously saving for college) are looking for MORE tax-advantaged accounts, not struggling to max out the ones available to them. If you use a Roth IRA for college, then you're forcing yourself to do more of your retirement savings in a taxable account. Meanwhile, you're leaving money on the table by ignoring a 529, which is at worst a double-tax-advantaged account, and in some states, a triple-tax-advantaged account somewhat like a Health Savings Account (not quite as good, as you never get a federal income tax deduction for contributing like with an HSA.) In addition, a Roth IRA is an asset protected account in almost every state. By spending it early, you are exposing more of your assets to creditors. Finally, the Roth IRA withdrawal rules are much more complicated than the 529 withdrawal rules. Put money in there last month? You can still take it out, earnings and all, to pay for an qualified expense this month.
High Income Professionals Aren't Most People
Ms. Turner talks about how many people can't afford to max out their Roth IRAs when their kids are young. But if you're a high-income professional with young kids, if you can't max out your Roth IRAs you have a serious spending problem. It's only $11K per year and should be pretty high on the funding priority list as retirement accounts go. I fund our Roth IRAs (via the backdoor) every January 2nd (along with my HSA and 529s.) Like most doctors, I'm also ineligible to contribute to a Coverdell ESA due to my income (phases out between $95K and $110K for single filers, and $190K and $220K for married filers.) It's not even an option. (Although I really like the sneaky trick to gift it to your kids and let them contribute, but that does come with the downside that it then becomes the kid's money, not yours.)
Besides, $2K a year isn't going to go very far toward a college education. Sure if you put $2K in every year for 18 years and earn 8% on it, that's $81K ($60K real.) But if you're like most, you probably didn't start at birth and missed a few years. It is far easier to lump sum payments into a 529 than an ESA. You can put up to 5 years of $14K/year payments into the 529 all at once. Then your spouse can do the same. As can the grandparents. You get the point, which is that the ESA contribution limit is a serious inconvenience if you really want to save up a large sum.
The children of a high-income professional are far less likely to qualify for any sort of useful need-based aid (I'm not talking about loans, a less than ideal way to pay for college.) If you are the sort who can afford to save up a bunch of money for college, your children aren't going to get much in the way of grants and need-based scholarships. And if they do, it'll be mostly to sucker them into going to an expensive school (where the grants will disappear by Junior year) instead of a local state school.
Perhaps most importantly for a high-income professional, the tax breaks of a 529 are extremely valuable. I get about $750 off my state tax bill every year for contributing money to a 529 instead of an ESA.
ESA vs 529
There is a random wrinkle in the law where some expenses are eligible to be paid from an ESA but not a 529. But they are fairly minor expenses in the grand scheme of things. I mean, 529 money can be used for tuition, fees, room and board, and books. The main items an ESA can cover that a 529 can't are K-12 related expenses. If you're actually using this account to save for college, that's not an issue. The computer exception is for K-12 use, not college use. I suppose you could buy it the week before high school graduation, but that's hardly a reason to use an ESA over a 529.
To sum up, don't get me wrong. I think ESAs are great. I didn't think they were so great a couple of years ago when the contribution limit very nearly went from $2000 a year to $500, but I did use them for the first couple of years I was in the military. But the main reason was a tax arbitrage scheme I had. When I was in the military I was a resident of a state without an income tax. So when I got out of the military and moved to Utah, I moved the money from an ESA to the Utah 529 and claimed the state tax credit I was eligible for by doing so. I also think Roth IRAs are great and have contributed to one every year that I have had income. But I think they're too valuable to burn on college, and I think following Ms. Turner's complicated scheme to save for college instead of just dumping money into a good 529 is probably a mistake for most high-income professionals.
PRO Rebuttal- Johanna Turner
For clarification, the article I submitted was aimed at two groups of readers:
- Residents, fellows, and other parents who have not yet achieved High Income Professional (HIP) status. WCI readers also include medical professionals who are not earning mid-six figures and may not be able to contribute much to 529 accounts.
- HIPs and others who either don’t want to fund a full education for their children or who believe that college costs may not continue on the current glide path.
In most parts of the country, 529s are not “…at worst a double-tax-advantaged account”; only in states offering tax breaks. WCI uses Utah as an example so I’ll take my state of Kentucky. Here are the questions parents face: Should I go to another state plan? Which state? Which option(s) to choose? Prepaid tuition or savings? Direct sold or advisor sold? Static or age-based? Will my investment in another state’s plan qualify for the school my kids choose in 5, 10, 15 years? Performance matters, and Utah has great numbers, but finding performance history is not easy for many state plans. Consumers are tempted to buy into an advisor-sold fund, resulting in higher costs and lower returns. As for supplementing with ESAs, have your parent fund your ESAs if you’re concerned your kids will spend the money.
What will you do if your children actually decide college is not for them? Let’s see – you’ve saved $500k for two kids and they have other ideas. Yes, these issues are addressed by 529 laws – simply find another family member who wants access to your money. Easy-peasy, right? Of course, your extended family member may be willing to pay you 50 cents on the dollar or not need that much funding. Use it yourself if you’re in the mood to go back to school, I guess. Otherwise, I can imagine a scenario where you are taxed on the gains and must recapture prior deductions and tax credits. Taxes would be assessed at your highest marginal tax bracket, not the more favorable capital gains rates for taxable accounts. And don’t forget penalties (although there are federal exceptions for death/disability, scholarships, and military). This could get messy…
Will college costs diminish?
Yes, I believe future generations will reap the rewards of competition in education. Do you really believe that college in 15 or 20 years will look and cost the same (inflation-adjusted) as it does today? If you’re not sure, why lock several hundred thousand into a 529? Low-cost community colleges, at $3,300 per year for full-time studies, now account for nearly half of all undergraduates. Other states may follow Tennessee’s initiative in ensuring their residents receive at least some of higher education for free.
Online education is also rising in popularity. Take MOOC programs like MIT-backed edX (over 5M students since inception in 2012) and Coursera. While the courses aren’t accredited – yet – the concept of accreditation itself may become outdated as the education landscape evolves. I believe we are on the cusp of a wave of innovation for higher education opportunities as universities get creative to keep up. Unfortunately, we’ll have to wait years to see who’s right!
“If you start contributing to a Roth IRA at 30 as a resident, it might enjoy tax-free growth for the next 60 years until you die. Then, as a stretch Roth IRA, it might grow for another 50-100 years tax-free.”
Do you really believe your heirs will live 50 – 100 years after you die at age 90? C’mon, doctor! If you leave your Roth to children that young (great-great grandkids?), don’t count on it remaining intact. (Side note: A taxable account is almost as good to pass value to future generations. They will get basis step-up with no RMD requirements.)
“By spending your Roth IRA early, you are exposing more of it to creditors.”
What would they get – college credits?
“Ms. Turner talks about how many people can't afford to max out their Roth IRAs when their kids are young. But if you're a high-income professional with young kids, if you can't max out your Roth IRAs you have a serious spending problem.”
Actually, I said, “Many new parents cannot fully fund a Roth IRA, max out 401k(s), and contribute to a 529 and/or Coverdell ESA…They may choose to sacrifice retirement savings in favor of college funding.”
“…the Roth IRA withdrawal rules are much more complicated than the 529 withdrawal rules.”
Really? For a med school grad?
“If you are the sort who can afford to save up a bunch of money for college, your children aren't going to get much in the way of grants and need-based scholarships.”
You’re making my point in a roundabout way. Not all physicians and dentists earn in the mid to high six digits. If you earn, say, $200k and have two kids in college at once, you very well could qualify for fin-aid. (btw, there are other reasons to complete the FAFSA, not the least of which is merit-based aid.)
Finally, experience tells me that students with skin in the game value their education and work harder than those who get a free ride. Before deciding how much to contribute to 529s, consider if you are letting the “tax tail” wag the “financial plan” dog. A Roth IRA is a wonderful way to grow your money tax-free but building wealth is only a means to an end. Consider all alternatives when planning for college.
CON Rebuttal- WCI
This post is already getting way too long, so I'll keep this short and just clarify a few things. First, when I say “double tax advantaged” I mean tax-protected growth and tax-free spending of gains. Triple tax advantage would include a state tax break on contributions, similar to (but not quite as good as) an HSA.
Second, those who are saving a lot of money for their kids to go to college will probably save a lot of money for their grandkids to go to college. Changing the beneficiary to pay for them seems far more likely than actually taking the money out and spending it on yourself to me, but I suppose if that's a big concern for you, then perhaps you want less in a 529.
Third, I suppose education could become cheaper. It is cheaper in lots of countries. I wouldn't plan my financial life around that sort of thing however. I would assume your children will be paying AT LEAST what college now costs. I think it is foolhardy not to.
Fourth, if you spend your Roth IRA on college while keeping a taxable account on the side, more of your money will be exposed to creditors, i.e. you will have less asset protection.
Fifth, the only financial aid I care about is need-based grants and scholarships. Don't expect a lot of those if you're making $200K, even if you have two kids in college at once.
Sixth, my children won't be getting any leftover Roth IRAs. They'll go to grandkids or perhaps even great grandkids with specific instructions, which they may or may not follow, to stretch it out as long as possible. Along with the money, they'll get a financial education. I fully expect that money to be stretched for at least 50 years after my death, unless legislation eliminates that possibility. 100? Okay, perhaps not, but it's possible.
What do you think? Would you use a Roth IRA to save for college? Do you use an ESA, a 529, both, or neither? Comment below!