One topic we frequently discuss with our retired clients is college savings for their younger family members. A common scenario involves a grandparent looking to open a 529 college savings plan and how best to fund it. Rarely does a client have a big chunk of expendable cash available, so we frequently must look at other avenues. Do you pull money from an IRA and increase your effective, and potentially marginal, tax rate? Do you sell capital gain investments in your after-tax accounts? We’ve had a client’s CPA advise him to distribute funds from his Roth IRA tax-free and use them to fund the 529 – a strategy that accomplishes nothing but put more restrictions on assets that already have similar tax ramifications to a 529 plan’s distribution. This leads us into the concept of a Roth IRA being used as a “Super 529.”
First, let’s compare Roth IRAs and 529s. Both a 529 and Roth IRA are funded with after-tax money, and if certain conditions are met, the money is distributed tax-free. Even though the conditions for tax-free distributions are different for a 529 and Roth – 529s require the funds be used for qualified education expenses, while Roth IRAs require the owner to be age 59½ or older and meet what is known as the Roth IRA’s “five-year rule” – they both have the exact same tax treatment when those conditions are met. (There are other, less common conditions and exceptions for each that need not be detailed here.) If you do not meet the conditions for either, you can expect to pay taxes on the amount of gain over your contributions plus a 10% penalty.
If both 529s and Roth IRAs essentially work the same way, why should a retiree pull money from a Roth to fund a 529? The short answer – they shouldn’t. If a retiree can take a Roth distribution tax-free, it means they have already met the conditions necessary for the Roth. Adding funds to an account with a new set of conditions that are more stringent does nothing but add more restrictions on how the money is eventually spent. Roth IRAs do not require the funds to be spent on anything specific. What if the grandchild for whom you funded a 529 turns out to not be college material? You could always change the beneficiary to a grandchild who is, but what happens when that grandchild gets a scholarship and does not need the money? With a Roth IRA, you do not have to assign beneficiaries for the distributions. If a grandchild does not go to college, the money can stay in the Roth IRA. A Roth also eliminates the need to retain receipts and records detailing that the funds were spent on education expenses.
One disadvantage the Roth IRA has is the annual gift limit, which restricts how much you can give to a non-spouse or non-dependent person without it being considered a reportable gift. The gift limit in 2020 is $15,000, and it is reasonable to assume a year of college education could be more than that. This will likely only impact grandparents or anyone else who do not claim the student as a dependent. One important exception to the gift limit rule, though, is when expenses are paid directly by the would-be gifter. A gifter could pay tuition directly to the school and rent directly to the dorm and not have it count toward the gift limit. Then additional gifts could be made directly to the grandchild for miscellaneous expenses. Spouses are also allowed to use split gifts, which could double the amount of allowable non-reportable gifts.
We previously mentioned the Roth IRA “five-year rule.” This provision could also limit the amount of distributions from a Roth. The IRS states that you must wait five calendar years since your original Roth IRA was funded or you will be subject to taxes and penalties on any growth attributable to the distribution. Importantly, once the five years have lapsed on any one Roth IRA, it satisfies the requirement for all current and future Roth IRAs. Any potential growth that could be subject to taxation or penalty comes out of the Roth IRA only after all tax-free contributions have been distributed, so the five-year rule could potentially have no impact depending on the size of your Roth and education cost. Even so, it makes sense to go ahead and fund a Roth IRA as soon as possible, even if it is only for a small amount, to get the five-year clock started.
One final note: Roth 401(k) balances have their own separate five-year rule that does not aggregate with Roth IRAs. If you were to roll your Roth 401(k) over to your first-ever Roth IRA, a new five-year rule would start. This is another reason to fund a Roth IRA as soon as possible.
If you have questions about how best to use an IRA to fund a college savings plan, please feel free to contact us – we’d be happy to sit down with you and talk through your options.
This article is Part 1 of a two-part series. See the follow-up here.
**While Baird does not offer tax or legal advice, our Financial Advisors regularly work with clients' attorneys and tax professionals to help ensure that all phases of wealth management are addressed