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Jan5, 2023

Should I Use a Roth IRA vs. 529 to Plan for College?

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In this episode of the Great Retirement Debate, Ed and Jeffrey discuss saving for higher education, and whether a Roth IRA or a 529 plan is the best option for that.

*Please Note: The recently passed SECURE 2.0 allows rollovers from 529 plans to Roth IRAs. This provision is not effective until 2024. It is NOT effective for 2023, but it is generating so much talk that it is worth mentioning.

Episode Transcript

[00:00:00] INTRO: Hi, I’m Ed Slott and I’m Jeff Levine. And we’re two guys who just love to talk about retirement and taxes. Look, our mission is simple to educate you the saver so that you can make better decisions because better decisions on the whole lead to better outcomes. And here’s how we’re going to do that each week. Jeff and I will debate the pros and the cons of a particular retirement strategy or topic with the goal of helping you keep more of your hard earned money. Yeah, but we won’t know which side of the debate we’re taking until we flip a. Winner of the coin flip gets to pick which side of the debate they want to argue. And both of us will have to argue in favor of our respective positions, whether we agree with them or not. At the end of each debate, there’s going to be one clear winner. You a more informed saver who can hopefully apply the merits of each side of the debate to your own personal situation, to decide what’s best for you and your family. So here we go, welcome to the great retirement debate![00:01:00]

[00:01:02] Ed Slott: Welcome everyone back to the great retirement debate. I’m Ed Slott, along with Jeff Levine. Hey Jeff.

[00:01:08] Jeff Levine: Hey, I, I like the intro today. Welcome everyone back. Like you’re speaking like Yoda today. This is good. Instead of welcome back. Welcome everyone back to the, this is I’m gonna have to do our entire podcast, like Mmm. Okay. That type of voice. What you, what you saying?

[00:01:22] Ed Slott: I think they heard some of the other debates and they’re coming back for more, because I hit a lot of the questions that we see from both financial advisors and consumers, and they wanna know how to make the right decision.

[00:01:34] Jeff Levine: It’s true. It’s true. Well, I got a good one for us today, Ed. All right. So obviously we know the cost of education. Like the cost of healthcare has risen quite precipitously over recent decades. And one of the questions that I get quite frequently is should I use a Roth IRA or a 529 plan if I wanna save for my, my child’s education or my grandchild’s education, what, what’s the best place for me to save?

[00:01:57] Ed Slott: Oh, that’s a good one.

[00:01:59] Jeff Levine: All right. Well, [00:02:00] let’s flip a coin as is our style and let’s see, uh, what do you want, Ed? You want heads or tails? I think heads. You always take heads. All right. Uh, the, and, uh, let’s see here. We’ll flip. It is, uh, heads Ed. You wanna take the side of..

[00:02:14] Ed Slott: Oh I’m gonna go with the Roth. My favorite.

[00:02:16] Jeff Levine: I’m shocked. You went with the IRA strategy. All right. Very good. Well, since, since, since you got to pick and you won, you can kick us off. Why? So again, situation here, someone’s thinking about you know, I wanna save, they already decided that they want to, like, it’s a goal for them. They wanna save towards education of a loved one. Why would you choose a Roth IRA over a 529 plan? And just at a high level before, before you can make the argument, for those who aren’t aware, right? Roth IRA, simply being the individual retirement account that is, uh, tax free. If you take it out in retirement provided you’ve met certain restrictions, no tax break going in. Uh, but you get a tax break on the way out. Whereas the 529 plan is a specific [00:03:00] account that is dedicated for the purpose of education, which we’ll talk about. So, so why choose the account? That’s not actually for education.

[00:03:08] Ed Slott: Because a Roth IRA can be for anything. And what most people don’t know about roths first in an ideal situation, you don’t touch a Roth account until. The purpose it’s intended for, for retirement, because you want to get the most years of that, of tax free income tax free accumulation, but let’s say you need it for school. It provides an excellent funding vehicle because most people are not aware, even though. The first thing people might say, but if, if you take it out early for education, won’t there be a tax or a penalty? Generally not, contributions to Roth IRAs can always be withdrawn tax and penalty free for any reason at any time. I’ll say that again. The original contributions that could be currently in 2022, [00:04:00] 6,000 a year or up to 6,000 a year can always be withdrawn at any time for any reason tax and penalty free.

[00:04:09] Jeff Levine: And when you say contributions, you just to, to clarify here for those listening, right? We’re talking about fresh money if you will going into a retirement account money, that’s never been in a retirement account before a a as opposed to let’s say a conversion where you’re taking existing retirement account money and then switching it or moving it into the Roth, right? This is just brand new money, fresh into the Roth that was in your bank account. Let’s say before.

[00:04:33] Ed Slott: Right, right. Uh, contributions. And you never have to worry about tax or penalty on those. Now I said on the contributions earnings on these accounts, they’re a different story, but under these complicated rules of which money comes out first, the earnings really will not be much of an issue, especially if the Roth IRA is just starting to grow because those funds come out less. What I like about the Roth is the flexibility. [00:05:00] You don’t have to use it for education. You can use it for anything you want. You could bet it on a horse if you want to. So there’s no, don’t do that. That’s not my recommendation. Unless it’s that 80 to one shot there. I would’ve put my Roth all the way in. If I had a time machine, but I don’t. All right. If you don’t know what I mean, go check the Kentucky Derby from earlier in 2022. Uh, other than that, you can put it in anything you want or use it for anything you want, including education. So it may be a good funding vehicle if you need the funds. Anyway, as I said, you’re generally better off obviously using Roth IRAs for the intended purpose to hold to retirement, because if you use it early, you won’t have as much later, but if you need the funds, you have ultimate flexibility. You don’t have to worry about a, a lot of arcane rules that Jeff will tell you about now. And I want to hear why he says, uh, all of this is okay.

[00:05:56] Jeff Levine: Well, I think what I’m looking at saving for education, [00:06:00] the big deal here is, is educate. Like, have you looked at the cost of education over the last few decades, Ed? It is. I mean, you have, you have two daughters of your own who went to school, that was pretty expensive, right?

[00:06:11] Ed Slott: Very expensive.

[00:06:13] Jeff Levine: And the most you can put into a Roth this year is how much.

[00:06:16] Ed Slott: 6,000.

[00:06:17] Jeff Levine: I’m not sure that saving $6,000 a year is gonna cover it forever. And so one of the benefits, the real big benefits of the 529 plan relative to the Roth IRA is that in large respects, there, there is no contribution limit. Now there are gifting limits you can give annually. So this year you can give, uh, $16,000 a person for 2022 without using any of your lifetime exemption. If you’re a couple you can give twice that amount or 32,000 be gift splitting. So you can, but, but that’s not the limit on how much you can give. In fact, uh, there are special benefits of the 529 plan where you can front load five [00:07:00] years worth of contributions or five years worth of gifts I should say, even though you don’t, uh, you just don’t give over the next four years then, but you can front load five years worth of gifts and not have it use any of your lifetime gift exclusion or lifetime estate tax exemption. They’re one and the same. Of course today, that’s not even a big deal for most people anyway, the estate tax exemption and gift tax exemption this year is, you know, more than 12 million per person for a married couple. We’re talking about more than 24 million. So effectively you, most people will never, ever have to worry about how much they’re putting in to a 529 plan, and the plans themselves effectively allow you to contribute as much as you want until you reach the maximum amount allowed by the plan, which in some states, Ed, I don’t think this is a particular coincidence is as high as $529,000. So, you know, that’s a lot of money. If you, you could put into a, a plan in those states, like [00:08:00] $500,000 and let it grow. Now, obviously not everyone has $500,000, but if we’re planning on saving for, uh, you know, for multiple children, right? Remember the Roth IRA doesn’t expand if you have more than one child or more than one grandchild. So you’ve got a family with three kids putting $6,000 away per year. I don’t know that that’s gonna cut it. That’s where the 529 plan holds a major edge over the Roth IRA.

[00:08:27] Ed Slott: Well, I’ll give you one there, but you are talking about the funding and who puts the money in, uh, most children are not gonna have $80,000 laying around that’s your, uh, 16,000 a year for the five years front loading. So it’s going to come mostly from grandma and grandpa. That’s why I see it. And that’s a good, that’s a good reason to do it on your side because I found grandparents in dealing with clients over the years, they are hesitant to give away money to young children, [00:09:00] but they love giving it away if it’s going for its intended purpose. If they know they can put 80,000 away for school, they love that that’s their legacy. They know their money will go for the intended purpose. But back on my side where you say it’s limited to 6,000, again, I’m going to the funding source. If we use the same grandma and grandpa, uh, are the ones paying the bill. They may have their own Roth IRAs that have marinated for a while. Meaning they have the five years and the 59 and a half, so they could withdraw. Any part of their Roth IRAs and their Roth IRAs may be, uh, hundreds of thousands of dollars. And they might love to use that for education, getting it out, tax free. So I think more we’re talking about who’s putting the money in. So on the Roth side, we’re not really limited to 6,000 a year, unless you’re only talking about the student putting that money in.

[00:09:55] Jeff Levine: That’s that’s a, that’s a, a fair point. I would, I, I would say though, that one of the things that would [00:10:00] concern me about, or not concern me, I would say, but one of the, the downsides of using let’s say a Roth is all that taxation. And while you do have federal taxation on the 529 planned contributions, there’s no tax break for those many states do allow a. Deduction for 529 plan contributions again, not, not the distributions we’re talking about here, but putting money in, which is what you were just talking about. If I’m putting money into a Roth, I’m paying tax on all of that, both at the federal and if I live in a state with estate income tax at the state level, the 529 plan may allow me a really nice tax benefit at the state level, thereby effectively subsidizing the cost of that education.

[00:10:41] Ed Slott: Yeah, that may be true. But the, the, the point you’re making that to have, like I said, grandma and grandpa possibly having hundreds of thousands in their Roth, they had to pay tax all those years, but that’s in the past, the money they have is already. If it’s held, like I said, for retirement, let’s say they’re in their seventies. [00:11:00] So they have the five years of 59 and a half let’s say. Any part of those funds that they may otherwise be leaving to grandchildren who no longer get the stretch IRA under the new rules can be dumped right in to education. It, it can come right out as a gift and still way under the, uh, gift limits. Uh, especially if they take it out of the Roth, there are no limits. You talked about a $16,000 annual gift limit, but if they take it out of the Roth, first of all, that’s income tax free. Assuming, you know, they have the five years and 59 and a half it’s a qualified distribution means no tax and penalty on anything. If they take it out of the Roth that’s income tax free. And if they take that money that they took out and made a check directly payable to the, for tuition to the school directly from them to the college or university, there is an unlimited amount that they can give. They’re not limited to [00:12:00] 16,000. That’s a special gift exclusion that most people don’t know about. It’s unlimited and it can be given to an unlimited number of people. So you talk about the expansion of the Roth. It could be used that way if they have enough in the Roth. And the other thing, uh, my argument against the 529, we’ve already seen people who have been using these things and they can’t use them up! They did so well, there’s too much money in there. And what if the kid, you know, is a dropout like bill gates and doesn’t even go to school?

[00:12:32] Jeff Levine: Well, at least at that point, you could take out the money from the 5 29 plan without a, a penalty, right? You, you you’d, at least the, if you get a scholarship, then you’d have the ability to, or, or, well, dropout is one thing.

[00:12:44] Ed Slott: If you got a scholarship, I know, God, God forbid, right. I was just kidding about the dropout, but maybe the kid doesn’t go to school, you know, there’s a big move. A lot of people wondering is college worth it. You hear what’s going on around there. And they say, maybe I should, you know, get a trade or go into my own business [00:13:00] and there’s a lot of that. Now when people..

[00:13:02] Jeff Levine: Well, there’s been at least a, so I’ll push back and say, at least there’s been an, an expansion recently for, uh, for more vocational types of uses for 529 plans, even outta the secure act, which was a law passed just a, a few years ago, there there’s an expanded ability to do that. Plus if your child doesn’t use it, uh, and you have other children or you have grandchildren, one of. The nice things like a Roth IRA always belongs to the, to the individual who creates the Roth. Right? The I and the IRA there stands for individual a 529 plan can actually be shifted within, you know, effectively an unlimited number of times within the family. So you can go brother to sister, you can go child to parent, you can go parent to child, right. Uh, and you can change the beneficiary of those accounts. So that some point, like if it’s not that one child, maybe it’s someone else who ends up using that money.

[00:13:53] Ed Slott: But the deal breaker for me, if the money’s left over and not used for the qualified education bills, you can have [00:14:00] a tax, so there goes your tax advantage and possibly a 10% penalty. So to me, uh, even exposing somebody with a 10% penalty is a deal breaker and the problem is. For the people funding this thing, these things, which I think you would agree is not likely the student, but more likely a parent or a grandparent

[00:14:19] Jeff Levine: Agreed.

[00:14:20] Ed Slott: They have to know these things, the, the build up of these plans. They have to know these things while a child may be 5, 6, 7, 8, 9 years old, uh, you know, hoping they go, uh, every grandparent and parent, I think, hopes their kids go to college, but what if they don’t? And there’s just too many rules in that area where I think the Roth is just open-ended you have the most flexibility. And if it comes down to giving it to the child for education, rather than leaving it to them, as I said before, I think most grandparents would like the idea or even parents, but I’m assuming grandparents would more likely have distributions that will be tax free. Cause they’ve [00:15:00] met the five years and 59 and a half. I think they would like giving while they’re alive to see that their gifts went to tuition every year, rather than just leaving them the cash at death and wondering, you know, every, every person I spoke with ever that was thinking of leaving large sums to young kids like grandparents, always wondering if they’re going to squander it.

[00:15:22] Jeff Levine: Well, in that case, maybe we use a trust and have the trust own a 529 plan or something like that. But I’ll give you, I’m gonna, I’m gonna, I’m gonna drop another one on your head here. What’s education. How much is it gonna cost in, in 20 years?

[00:15:37] Ed Slott: Two.

[00:15:39] Jeff Levine: Two?

[00:15:40] Ed Slott: Too much!

[00:15:40] Jeff Levine: Ah, too much. Yes. Well, how much?

[00:15:43] Ed Slott: Way too much.

[00:15:45] Jeff Levine: Okay. All right. But do you know?

[00:15:47] Ed Slott: Well, I don’t know, but I know it’s escalating and, uh, and we may even hit a pushback point. Again, this is all a prediction. We don’t know where it’s gonna be in 20 years. I know you’re trying to make a point, but at some point it’s [00:16:00] gonna go up against the ceiling and it’s not gonna be affordable for people.

[00:16:03] Jeff Levine: Well, I think we’re probably already starting to see some of that, but, but we don’t know what the future holds. And one of the, the really nice things about a 529 plan is they come in two flavors largely, so far, we’ve talked about effectively the education savings plan version, like almost the retirement account version of a 529 plan. But many states have prepaid tuition plans, right? Where you effectively can lock in the cost today. You can know what you’re paying. You know, child is born today. You can start that now and, uh, and get it going for them and you have locked in effectively the cost of that education in the future. So even if there are dramatic spikes in, in the education costs, as we’ve seen over the last few decades, you are not going to have to worry about the unknown. You will lock in a rate that you can effectively again, what, you know, we don’t know what future rates will be for college. Uh, but we do know what [00:17:00] it would cost today to get into one of those plans and so you can cap your cost for that student using a 529 prepaid tuition style plan, where with a Roth IRA, you will be completely at the mercy of what, uh, of what the future holds.

[00:17:16] Ed Slott: That’s true. Actually, I, I, so I’ve seen that situation firsthand. Somebody who, uh, roomed with my daughter in college, her parents, you know, when she was born, put away in one of these lock in plans, the prepaid plan, they probably paid a lot less than you, right? Well for a number of reasons, but for one of the reasons they locked in it at some ridiculous number, I think it was under 10,000. Like it was bizarre. Uh, the other reason was, uh, the resident of a certain state and all of that stuff. But, uh, But that was unbelievable. They locked in that rate. So, uh, that’s another point, uh, good point for 529s, but I’ll throw something else at you, which I’m sure will be a softball for you. We didn’t cover it. Uh, [00:18:00] the Roth, I said, have no problems, especially for financial aid. They’re not included the Roth itself. The account itself is not included on that application. Yet 529s are.

[00:18:13] Jeff Levine: That’s fair. But if you take money out of the Roth IRA, even though it’s a tax free distribution, that income will be added to the FAFSA form as income and, and that could make, uh, that could, that could have an even significant, a more significant impact on reducing aid in the future. So effectively, if you’re going to use the Roth as your funding source, if you’re looking for any sort of student aid, you may not actually be able to tap the Roth until the child is gonna be a junior in school when you’re past the time that, uh, the, the FAFSA form, the income reported on the FAFSA form would impact the aid eligibility, which means you’ve gotta come up with income for the first two years, where, where you gonna come up with that? Are you gonna pay for it out [00:19:00] of income? That could be a huge hit to someone’s income for the year. And if not that, where else are you now putting, you know, are you now subjecting that child or student to loans that, uh, that you may not have wanted to saddle them with for those first two years? What, like what becomes the game plan there?

[00:19:17] Ed Slott: Well, I think we can both agree on while we’re talking about 529s versus Roths we’re doing that to eliminate the uncertainty of student loans, because we know that’s just going up the wrong. That’s a disaster. I mean, there’s just no coming back from that. Let me ask you a question, cause I’m not even sure about this. You said, uh, that the, the Roths, when the funds come out are subject to the FAFSA. But what if, uh, for, for student aide but what if it’s coming out of grandma and grandpa’s Roth, is that still affected? I’m not sure myself, but you were saying it affects it if it’s coming out of the student’s own Roth, but I’m saying it’s less likely under my scenario. It’s more likely the big [00:20:00] money’s coming out of grandma or grandpa’s Roth. And would that have that same effect? I’m not sure.

[00:20:05] Jeff Levine: No. No. If it’s it’s grandma and grandpa’s Roth, it would not grandma and grandpa would….

[00:20:09] Ed Slott: Right, that was the point I, I wanted to make. So it’s not as much of a concern. And if the child has that much in their Roth, then maybe it is a concern. But again, we have to look at who’s paying the bills. I think what the kind of bills we are talking about for education, which we both agree are escalating, will be lot more than likely coming from somebody else’s funds. I mean, uh, you agree with that, right?

[00:20:33] Jeff Levine: Well, not, not the student probably, but I mean, look, some students are. Great. And they would save it for themselves, but we’re really, I think we’re talking about here a family decision, but a parents five, a parents’ Roth IRA distribution would certainly impact their child’s, uh, their, their child’s saving cause the parents’ income goes on the FAFSA form.

[00:20:55] Ed Slott: Right, but that’s why I’m talking about grandma and grandpa, because from what I see, that’s the [00:21:00] more likely funding vehicle.

[00:21:02] Jeff Levine: That’s fair.

[00:21:03] Ed Slott: Larger Roth IRAs and there are Roth IRAs can be withdrawn tax free.

[00:21:08] Jeff Levine: Yes. Yeah. If, if for the grandparent that would be a major edge to the Roth IRA. If it’s for the parent, it would be a little bit more of, uh, of a difficult situation.

[00:21:17] Ed Slott: And more, even more difficult. So let’s bring it down. If it’s, if we’re talking to the student alone, I don’t even know if that’s practical. Uh, if the, if it was the student’s choice between a Roth and a 529, I think like we do it on these programs. That’s a coin flip. Gotta get the money from somewhere.

[00:21:37] Jeff Levine: That’s it? Well, if you’re able to do it, kudos to you, cuz it’s not easy if you’re a student, that’s for sure.

[00:21:43] Jeff Levine: Yeah, well, Ed I think we’ve covered a lot of great information today for those thinking about the various ways to save for college. And of course these aren’t the only two ways you could also save in a taxable account. Some people use life insurance, uh, cash value, life [00:22:00] insurance, as a tool. There are any number of ways in which to save for college. Uh, but ultimately we covered today two key areas, which are Roth IRAs and 529 plans and both of them have the benefit of being tax free and penalty free. Now different ways the Roth gets there once you reach a certain age or as you pointed out contributions from the Roth at any time, for any reason, right. Can be distributed tax and penalty free. The 529 plan all the growth there is tax and penalty free. If used for qualified education purposes, the Roth IRA is more flexible, but that flexibility comes at a cost of limited contributions per year. So for a, uh, a parent or someone who doesn’t yet have a, a large established retirement account, they may be limited as to how much they’re able to put away for their child’s education. Whereas on the 529 plan, there’s effectively no contribution limit. Only the maximum amount that a plan will allow it to be in there, which are oftentimes in the hundreds of thousands of dollars. [00:23:00] Well, more than anyone would wanna put in and ultimately, uh, we’re talking about folks who are fortunate enough here in both situations to be able to save with the idea of these dollars going for retirement. One thing, Ed, while we, we may have taken opposite sides here. One thing I know, we agree on that’s um, a related issue is that there are no loans for retirement and so if it’s you or your child or your grandchild going to school or versus your retirement, prioritize your retirement. We agree on that one.

[00:23:33] Ed Slott: All right, nobody wants a mortgage on their retirement account.

[00:23:36] Jeff Levine: Indeed. it can’t happen. Well, Ed, we come to the end today and as we always say, there are two sides to every coin, but your life and your important decisions are too important to be left up to that coin flip. And that’s why one thing you and. Always agree on is making sure you’re talking through these difficult and complex decisions with a [00:24:00] knowledgeable financial or tax advisor so that you can weigh the pros and cons of different decisions against your own specific set of goals and circumstances. If you wanna continue the conversation with Ed and I we’d love to hear from you, you can reach out to Ed on Twitter at @TheSlottReport. That’s @TheSlottReport with two Ts and you can reach me at @CPAPlanner. Again, that’s @CPAPlanner. Tell us what we missed. Tell us if you have an additional idea on a benefit or a drawback from either the 529 plan or the Roth IRA that you think we should hit on. Or if you have an idea for a future topic, we’d love to hear from you too, until then thanks for listening to us, Ed as always, this one was fun.

[00:24:39] Ed Slott: Okay, Jeff, we’ll see you all on the next episode of the great retirement debate.

[00:24:47] OUTRO: Jeffrey Levine is chief planning officer for Buckingham wealth partners. This podcast is for informational and educational purposes only, and should not be construed as specific investment accounting, legal or tax advice. Certain information mentioned may be based on third party [00:25:00] information, which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but it’s accuracy and completeness cannot be guaranteed. The topic discussed in corresponding arguments are those of the speakers and may not accurately reflect those of Buckingham wealth partners.