529 Essentials: 529s vs. IRAs

This week, we will compare and contrast 529s and Individual Retirement Accounts (IRAs) for college financial planning.

Two Basic Types of Retirement Vehicles Used for College Financial Planning: IRAs and 401(k)s. Both retirement investment types allow families to save money for education with tax exempt asset growth. While money saved in a 401(k) can be withdrawn through a loan that must be paid back, there is not a special tax provision for higher education as there is for IRAs. Therefore, this article will focus on comparing 529s to Traditional and Roth IRAs. For simplicity, this article will focus on using the vehicles to pay for higher education, as opposed to the merits of obtaining the goal of college and retirement together or prioritizing one higher than another. That being said, the next section on market sizing notes the high volume of assets earmarked in retirement vehicles for college financial planning given the college affordability gap currently in place. Therefore you as an advisor can provide value by knowing these differences in investment vehicles, selecting the right investment vehicles based on the unique needs of your clients, and helping to ensure planning for one goal does not negatively impact the other due to lack of planning.

Market Sizing: As of December 2015, 529s allowed 12.7 million families to save over $253 billion in assets based on data by Strategic Insight. Of that, 11.6 million families saved over $230 billion in 529 savings plans while 1.1 million saved over $23 billion in 529 prepaid accounts. In addition to the $253 billion in 529s, families have saved approximately $103 billion in 401(k)s and $80 billion in Traditional or Roth IRAs for college financial planning as of December 2015. Together, families have saved approximately $183 billion in retirement assets for the goal of college financial planning as of December 2015. 

Compare and Contrast:

— Income Limit: While 529 plans do not have an income limit, Roth IRAs have income limits and Traditional IRAs have both income limits and restrictions based on whether their employer offers a retirement plan. Also, Roth and Traditional IRAs require taxable compensation in order to make a contribution

— Age Restrictions: While there are not any age restrictions on 529 college savings accounts or Roth IRAs, Traditional IRAs do now allow contributions after the age of 70.5 or older

— Contribution Limits: 529s allow investors to contribute up to the annual gift taxing limit of $14,000 per year per account-owner beneficiary relationship, or $28,000 per joint filing married couple as of 2016. Additionally, 529s allow an accountowner to make five years of gifting in one year such as $70,000 per single filer or $140,000 per joint filing married couple. In contrast, the most someone can contribution into all Traditional and Roth IRAs in one year is the smaller of $5,500 in 2016, $6,500 if the person is 50 or older or one’s taxable income

— Tax Benefits on Contributions: Though there is not a federal tax deduction for contributions into 529s, residents in over 30 states plus D.C. receive a state tax deduction or credit for contributions into a 529 plan. Traditional IRAs may provide a federal tax deduction to varying degrees based on income and whether or not the employer offers a retirement plan at work. Roth IRAs do not provide tax-deductions on contributions.

— Market Risk: All three investment vehicles provide tax-deferred growth, and may or may not be open to market risk based on self-directed investments offered by the plan provider and chosen by the investor. 

— Investment Changes: Roth and Traditional IRAs allow for unlimited investment changes per year, while 529s are granted two investment changes per year.

— Account Control: 529s allow the accountowner to maintain control of the account, and allow for an unlimited number of rollovers if the beneficiary is changed to a member of the family of the previous beneficiary. Therefore, 529s allow changes in beneficiaries while the accountowner maintains control of the account. Traditional and Roth IRAs also allow the accountowner to maintain control of the account.

— Financial Aid: 529 assets increase expected family contribution (EFC) by 5.64%, but distributions from 529s do not impact EFC. While parental assets in IRAs do not impact EFC, distributions of principal and earnings do increase EFC at the rate of income which is up to 47%. Therefore IRAs used to pay for college expenses increases EFC by more than 529s.

— Qualified Expenses at Eligible Institutions: 529 savings plans, Traditional IRAs and Roth IRAs can all be used for any qualified higher education expense such as tuition and fees, books, supplies and computer technology for the vast majority of colleges and universities in the U.S. and many abroad so long as they are eligible for financial aid from the U.S. Government. Non-qualified distributions from 529s can be made, though the earnings portion will be subject to tax and a 10% penalty. There are a list of exemptions to this 10% penalty, as covered in a prior 529 Insider “529 Essentials” column. Traditional and Roth IRAs do not need to be distributed for a specific purpose.

— Distribution Restrictions: 529s allow distributions to the school, accountowner or beneficiary. For Roth IRAs, distributions made after investing the assets for at least 5-years and after the age of 59.5 can be made without penalty or tax. If the age is 59.5 or younger, the earnings portion of the Roth IRA distributions made for qualified higher education expenses are taxable and without the 10% penalty. This penalty is only waived if the distribution is less than the adjusted qualified education expenses (AQEE). If distributions are greater than AQEE, then the excess is subject to tax and the 10% penalty. Distributions from Traditional IRAs are taxable, though the 10% penalty is waived when used for qualified higher education expenses. Also, Traditional and Roth IRA qualified education expenses must be for yourself, your spouse or your (or your spouse’s) children or grandchildren, while that list of family members is much more comprehensive for 529s.

Therefore, advisors, accountants and estate planners should understand the key product features of 529s and IRAs, ensure the most appropriate investment vehicle is used for the specific goals of your clients and help your clients with college financial planning so that it does not negatively impact other goals in mind

Next week, we will compare and contrast 529 savings plans and Savings Bonds.