Outstanding student loan debt in the U.S. now tops $1.5 trillion. Yes, that’s trillion with a T. This has led to a national debate about what can be done to help college students and their families manage their student loan debt burdens.
Of course, the best way to manage student loan debt is not to acquire any in the first place. The good news is that there are several different tax-advantaged savings vehicles you can use to save money to pay for your child’s college education expenses, instead of taking out student loans.
Two of the most common college savings vehicles are Section 529 plans and Roth IRAs. Here is an overview of each of these types of accounts to help you determine which might be a better option for you and your family.
529 Plans Offer Tax Breaks
Section 529 plans have become one of the most popular college savings tools in America over the past two decades. Not only do they enable you to sock away money now to help cover college expenses later, but they also offer valuable tax breaks. Investments in the account are able to grow on a tax-free basis and can be withdrawn tax-free if the funds are used to pay for qualifying education expenses. In addition, some states also allow local residents to deduct 529 plan contributions on their state income tax returns.
Qualified expenses include a wide range of different costs associated with attending college, including tuition, fees, books, room and board, computers and internet access.
Additionally, students don’t have to attend a school in the state where you open their 529 plan — they can go to school at any college in the country that’s eligible for Title IV federal student aid, as well as some overseas colleges and vocational-technical schools.
The Roth IRA: More Than Just a Retirement Tool
When most people think of Roth IRAs they think of them as a retirement savings tool. But Roth IRAs can also be used to help pay for college expenses.
Here’s why: Contributions you make to a Roth IRA can be withdrawn at any age and for any purpose without being subject to taxes and penalties. This includes paying for college education expenses. Note that this tax-favorable treatment only applies to Roth IRA principal, not earnings.
One strategy employed by some families is to withdraw some of their Roth IRA principal to help pay for college expenses while leaving the earnings intact to help cover their living expenses in retirement. Using this strategy, you can use a Roth IRA to kill two birds with one stone.
Factors to Consider: 529 Plans vs. Roth IRAs for College Savings
So which type of savings vehicle — a Section 529 plan or a Roth IRA — is a better option for saving money to help pay for college? The answer depends on several different factors.
For example, how certain are you that your child will attend college? Funds in a 529 plan must be used to pay for qualified college education expenses. Therefore, if you’re not fairly certain your child will attend college, you might be better off using a Roth IRA to save for college.
You should also consider the value of the tax benefits offered by each type of savings vehicle. The tax benefits of Roth IRAs are hard to beat: While you don’t receive a current tax deduction for contributions, funds grow tax-free and can be withdrawn tax-free to pay for college or retirement living expenses. This benefit tends to outweigh the tax-free growth offered by 529 plans over shorter periods of time.
Don’t Rob Your Retirement
For many families, the most important factor should be whether they are putting enough money aside to help ensure a comfortable retirement. This should generally take precedence over whether you’re saving enough money to pay for college education expenses.
The reason is simple: There are many potential sources of money you may be able to tap to help cover college expenses, such as loans, grants and scholarships and financial aid awards. Also, your child might be able to work on a part-time basis to generate income to help pay for college-related expenses.
However, you can’t really take out loans or get scholarships and grants to help pay your living expenses in retirement. In recent years, most employers have replaced traditional pension plans with defined contribution plans, which places the primary burden for retirement savings on employees. And while you may be eligible to receive Social Security retirement benefits, these often aren’t enough to fund a comfortable retirement for many people.
Keep in mind that this isn’t necessarily an either/or proposition. Many families contribute money to both a 529 plan and a Roth IRA. This strategy can provide you with the highest degree of flexibility in saving money to meet both of these critical long-term financial goals.
Talk to your financial planner about the best ways for your family to save money for college education expenses.