Outstanding student loan debt in the U.S. now exceeds $1.7 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.
If you’re financially able, the best way to manage student loan debt is not to acquire any in the first place. 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 Title 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.
What is a Title 529 Plan?
Title 529 college savings plans were first established in 1996. Nearly 13 million such plans have been established since then and these plans hold more than $328 billion in assets, according to Strategic Insight.
Funds saved in a 529 plan can be used to cover a wide range of education expenses including tuition, fees, books, room and board, and computers and related services like internet access. As long as the savings are used to pay for qualified education expenses, distributions and earnings within the plan grow tax-free. Also, some states allow full or partial deductions for 529 plan contributions.
There are two main types of Title 529 plans:
- Prepaid tuition plans
- Investment savings plans.
Prepaid tuition plans lock in a specific amount of future tuition at current prices so you have more cost certainty. For example, you could buy four years of college today for a young child at current tuition rates, which are probably lower than they will be in the future.
With investment savings plans, you can invest your college funds in market securities in order to potentially maximize returns. However, there’s no guarantee that your investment returns will be positive so there’s risk involved with this strategy.
Another benefit is that students do not have to attend school in the state where the 529 plan is opened. Funds can be used to pay for education expenses at any school that’s eligible for Title IV federal student aid, including some vocational-technical schools. Most states now offer Title 529 plans so you can choose the plan that’s best for your family.
What is a Roth IRA?
Roth IRAs were first established in 1997 as an alternative to traditional IRAs. Roth IRA investments grow without the burden of taxation, which can result in a larger next egg when you retire.
In most situations, you can withdraw funds from a Roth IRA income tax-free after you turn 59½ years old. This can result in having more income at your disposal after you retire. Unlike with traditional IRAs, however, you don’t receive a current tax deduction for contributions made to a Roth IRA.
While Roth IRAs were designed primarily as a retirement savings tool, there’s one feature that also makes them a viable investment option for college savings: Roth IRA contributions can be withdrawn at any age and for any purpose without being subject to taxes and penalties — including paying for college education expenses.
Note that this applies only to Roth IRA contributions, or principal. Taxes and early withdrawal penalties will generally be assessed against Roth IRA earnings that are withdrawn before age 59½. One exception: Tax- and penalty-free withdrawals of up to $10,000 can be made from Roth IRAs at any age to buy a first home.
Factors to Consider: 529 vs. Roth IRAs for College Savings
So which type of savings vehicle — a Title 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 vs a 529 plan 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.
One college savings strategy is to withdraw Roth IRA principal only to help pay for college expenses while leaving the earnings alone for retirement living expenses. This way, you can use a Roth IRA to kill two birds with one stone.
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. Be sure to talk with your financial planner about the best ways for your family to save money for higher education expenses.
You can also use online financial tools like Personal Capital’s to stay on track with your large-ticket savings goals. Millions of people use the free technology to help them gain control of their personal finances. Using the tools, you can:
- Estimate and plan how much you should be saving today to college costs down the road
- Ensure you’re on track to retire by your target date and calculate your projected monthly income
- Analyze your investment performance and compare your current allocation to the ideal target allocation for your personal risk tolerance
- Uncover hidden fees in your mutual fund, investing and retirement accounts