Financial advice I will give to my little girl – Self-planning for financing education
At the end of most of my lectures, the moderator usually asks, “What else should our audience know?” I always look at the younger members of the room or on the screen and think – if only I knew this when I was your age.
While my job is to provide financial advice and wealth planning to clients who have already built a significant amount of wealth, there are many basic planning strategies that apply to those just starting out in their careers, things that, frankly, I wish I knew when I was growing. So, I’m writing this four-part series on planning advice I’ll give my younger self. Topics will range from planning for college savings, young families, retirement, and caring for elderly parents. This first article focuses on planning college savings.
Saving for college is often thought of from the perspective of a parent saving for a child, and if you’re one of the lucky ones whose parents can afford to do it for you, good for you. However, college savings, or more appropriately education savings, is not a dominance strictly reserved from parent to child. As an adult, you can start thinking about saving for higher education and how to do it in a tax-efficient manner. Specifically, I’m referring to the 529th College Savings Plan and the Roth Individual Retirement Account (IRA).
529 College Savings Plans isn’t just for kids
The 529 College Savings Plan is a tax-advantaged vehicle designed to provide education. Funds held within these accounts can add up to deferred income tax, and when the money is eventually distributed to use qualified education expenses, it will also be exempt from income tax. In other words, earnings and appreciation from investments held in a 529 account can be completely exempt from income tax if they are used for education needs.
For many, the first experience with a 529 account was when a young parent opened one for a newborn baby – this was definitely my case as my son’s first 529 account was opened a few months after his birth. Here’s the tip I wish I had known years ago – You can open an account for yourself. Rather than putting your additional savings early in your career into a savings or investment account where interest and growth are taxable, consider instead putting those savings into a 529 account for your own benefit. If you go to graduate school, you can then use that money to pay for tuition, books, and room and board. As with any tax-free account, an income tax-exempt compound growth value can be a good dividend boost. In addition, some states also offer a tax deduction or credit for contributions to a 529 account.
You may be wondering – what if I don’t go to graduate school or receive external funding like a scholarship? Funds can still be withdrawn from a 529 plan for any use (that is, for non-educational use), but the withdrawal will be subject to income tax at the time of distribution and a 10% penalty if it is not used for qualified education expenses. However, you can still go ahead, because depending on the growth of the investment and the length of time the 529 account has been opened, the value of the income tax-exempt compound growth over the years may outweigh the tax and penalty for taking an ineligible withdrawal.
More likely, and where the long-term vision comes in, is to think of the 529 account as a means with tax advantages not just for for you Education, but for anyone dear education. You can rename the beneficiary of a 529 account to an eligible family member (for example, another child, niece, nephew, or in-laws), which means if you don’t ultimately need the money for your educational needs, you can effectively “Transfer” this money to another person for his/her education, all while gaining the same income tax benefits.
Later, not only would I have to open a 529 account for my law education, but I should have continued to contribute to the account and “transfer” it to my son when he was born as a new beneficiary. Had I done that, I would have started my son’s college savings through 15 years of tax-free compound growth.
Roth IRAs aren’t just for retirement
Another tax advantage vehicle that can be used for education savings is a Roth IRA. These accounts are often thought of for retirement purposes, which is primarily how they are used. The advice I would give my younger self is to consider using this strategy to fund education as well and not just for retirement.
Similar to a 529 plan, profits and appreciation earned on investments held in a Roth IRA are income tax deferred, with the potential to be ultimately tax-deductible. Contributions you make to a Roth IRA can be accessed at any time without tax or penalty. Furthermore, when dividends and growth are distributed outside of a Roth IRA, it’s also exempt from income tax (provided it’s a qualified distribution—a little more on that), regardless of use.
The Internal Revenue Service (IRS) also provides a Penalty–Free Distribution from a Roth IRA to pay for higher education expenses for yourself, a spouse, children, or grandchildren, provided the distribution does not exceed the year’s expenses. Of course, if the assets are not ultimately required for education, a Roth IRA can eventually be used for retirement.
There are some key differences between 529 plans and Roth IRAs that one must take into account when planning to use either for education savings purposes. First in time. While you can make a distribution from a Roth IRA at any time, there will be a 10% early withdrawal penalty if the distribution is made before age 59½, unless an exception applies. If the distribution is made within the first five years after contributing to a Roth IRA, there will also be income tax levied at that time on the earnings (capital withdrawal is exempt from income tax). Therefore, a Roth IRA is likely to be best viewed as a child’s education savings strategy when you opt out after a time frame of five years from the first contribution and more than 59 years (of course, it is also available if one is obtaining higher education at a later age ).
Another important difference is on the income limits. In order to qualify for contributions to a Roth IRA, an individual’s income must be below a certain threshold. In 2022, that minimum was $144,000 for singles and $214,000 for married people. On the other hand, the 529 plan has no income restrictions, so one can make contributions regardless of income level. Therefore, one must keep in mind an individual’s income potential, because if your income starts to exceed the specified minimum, a Roth IRA may not be available.
Of course, these two strategies are not mutually exclusive, and if there is enough excess savings, you can always contribute to both the 529 plan. And the Ruth Ira.
When considering which option is right for you, there are many other factors that are beyond the scope of this article, such as:
- Investment options offered in the plan: 529 college savings plans may offer different investment options compared to Roths and may be limited in general.
- Contribution limits: If you’re under 50, you can only contribute up to $6,000 a year to a Roth IRA for 2022. Meanwhile, with 529 plans, there are no limits, although gift taxes can take effect when contributions arrive. To over $30,000 per year couple.
- Impact on Financial Aid: Eligibility and income qualifications vary between 529 and Roth and will depend on many factors such as timing and ownership.
Although you should always consider consulting a financial advisor before making any final decision, I wish I had known even to ask the question when I was younger.
Hope this helps, and keep an eye out for next month’s column: Financial advice I will give my little girl Self-planning for a young family.
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Chief Wealth Strategist, Wilmington Trust
Alvina Lu is responsible for the family office and strategic wealth planning at the Wilmington Trust, part of M&T Bank. Alvina has previously worked with Citi Private Bank and Credit Suisse Private Wealth and is a practicing attorney at Milbank, Tweed, Hadley & McCloy, LLC. She holds a BA in Civil Engineering from the University of Virginia and a Juris Doctor from the University of Pennsylvania. She is a published writer, frequent lecturer, and has been cited in major media outlets such as The New York Times.