Dear It’s Complicated: Are 529s Still a Good Idea if College Might Not Be in the Cards?
Angela Colley — It's Complicated
Dear It’s Complicated: I’m not sure my young child is “college material.” Should I fund a 529 anyway? I don’t want to discourage higher education, but I do want to lend some financial support for whatever they want to do, be it start a business or pursue a music career or attend a liberal arts college. Since 529s take a steep penalty if the money is withdrawn for other uses, what are some other options to consider that are either interest-bearing or tax advantaged?
Saving for college is always tricky.
It’s admirable that you’re taking these steps now to do what you can to help your child in the future—whatever that future may hold. The average cost of four-year public universities is $9,650 a year, and private universities run around $33,480 a year. If tuition continues to rise, your child could be on the hook for a bill well into the six figures by graduation.
But, you’re right, not every child is college-bound. Your youngster may grow up wanting a different path in life, and some college-savings options come with hefty penalties if you don’t end up using the money to fund a traditional higher education.
In your case, it all comes down to comparing options and deciding what offers the least risk and the biggest potential for helping your child.
Let’s start with the 529 plan.
529 college savings plan
On a basic level you contribute after-tax dollars into an account that earns investment gains. As you contribute year after year and your investments pick up steam, you’ll build a nest egg your child can use for most college expenses. If you pull the money out to pay for tuition, books, or room and board to attend a qualifying college, you won’t pay taxes on any gains. Some state-sponsored plans come with added benefits like additional tax breaks and matching funding. Annual contribution limits are higher than some other options too—typically $14,000 per year.
But there are a couple of potential snags with a 529 plan. Since these plans are run through individual states and programs, there’s no one-size-fits-all list of requirements. Depending on where you live and which options you choose, you’ll have different investment choices, different contribution limits, and different fees.
When looking at 529 plans you’ll want to watch out for the fees. Your plan could come with “program manager fees, state fees, annual distribution fees, total annual asset-based fees, account maintenance fees, and miscellaneous fees,” says Aaron Milledge, founding partner of Targeted Wealth Solutions. The key to getting the best deal comes down to understand the “all-in” cost. You may have to hunt for it a bit, but the fee schedule should be available either online or in documentation sent in response to inquiring about the plan. Alternatively, you can use a broker to figure it all out, but you’ll pay more for that service.
In your case, if you do decide on a 529 plan and your child does pursue further education after high school, you may be in the clear. Eligible educational institutions don’t just apply to state schools. “It's important to note that the definition of an ‘eligible educational institution’ is broad,” says Milledge. “The IRS explains it as ‘any college, university, vocational school, or other post-secondary educational institution eligible to participate in a student aid program run by the U.S. Department of Education.’” But even that definition is a tricky one to hang your college savings fund on. To get a better idea, you could contact a few colleges in your area to see if they participate before you start investing.
If your child decides to do something else in life, things will get trickier. You’ll still be able to withdraw the funds (including any gains) to give your child a financial boost, but you’ll likely get smacked with some hefty penalties. “If you withdraw from a 529 for nonqualified expenses, the earnings portion will be subject to federal income tax and a 10 percent penalty. You could even owe taxes at the state level if you previously received a deduction or credit,” says Brandon LaValley, partner and financial adviser at Target Wealth Solutions.
The trouble is, predicting what your tax penalties might be on an investment account years in the future isn’t easy. If you want to keep pursuing the 529, we’d suggest talking to a CPA to get an estimate of what your penalties might look like. You also have other options.
You can use a Roth IRA as both a retirement account and a college-funding account. Roth IRAs do require after-tax contributions, but you’re allowed to grow your money tax free (provided you follow certain rules). You can also remove funds from a Roth IRA penalty-free to pay for qualified education expenses, providing your child does decide to go to college. You’ll also have more investment choices and flexibility in how you manage the account.
There are a few downsides to Roth IRAs. You can’t contribute as much annually. The 2017 limits are $5,500 a year if you’re under 50 years old and $6,500 if you’re over 50. There are also income limits. If you’re single, you must have a modified adjusted gross income under $133,000 to contribute. The limit is $196,000 for married couples. If you’re close to the AGI limit, you won’t be able to contribute the full annual amount. (Though, there is a fairly complicated backdoor method for converting to a Roth IRA when you’re over the income limit.) Fees for a Roth IRA may be cheaper than 529 savings plan, but with so many variances in state plans make sure you’ve compared them before you go all in on a Roth.
Then there’s still the issue of predicting the future. If your child decides against college and you’re 59 or older, you can simply withdraw the funds for your child without penalty. If you’re under 59, you’ll face tax penalties and another 10 percent penalty on your earnings.
You could also skip the plans and manage the funds yourself. While you have some other options like socking away money in a savings account, those won’t grow much by the time your child is ready to use them. If you’re looking for something with investment earnings potential, you may want to consider individual investment options like mutual funds.
Going this route has one big benefit—freedom. “There's great flexibility in a taxable account from both an investment selection and usage perspective. The parents could just as easily help the child with a startup as they could with college expenses,” says LaValley. You won’t have to worry about maximum contribution limits, income restrictions, or age restrictions. And no matter what your child wants to do, you’ve got it covered, penalty free.
But there’s a reason so many people opt for strategies like the 529 savings plan. If you go the independent route, you won’t get the tax breaks.
In the end, the best thing to do might be to compare your “all in” costs across several options. Look at fees and account minimums as well as the potential for taxes and penalties on the back end if college isn’t in the cards. You probably can’t get an exact figure this far out, but you should get a good enough idea to put you on the right track.