- You deposit after tax dollars into mutual funds, bonds, etc and the money grows tax free
- Any money withdrawn for educational expenses is not taxed
- Any earnings withdrawn for non-educational expenses is subject to a 10% penalty, plus it will be taxed
- Any contributions (i.e. principle) can be withdrawn at any time, without penalty – tax free
If you’re like me, you also make contributions to a Roth IRA as part of your retirement plan. Some basics about Roth IRAs include:
- You deposit after tax dollars into mutual funds, bonds, etc and the money grows tax free
- Any earnings (i.e. interest) that you accrue can with withdrawn tax free after you turn 59 ½ years old
- Any earnings withdrawn before age 59 ½ (with a few exceptions) is assessed a 10% penalty, plus it will be taxed
- Any contributions (i.e. principle) can be withdrawn at any time, without penalty – tax free
One drawback of 529b plans is that the earnings have to be used for education (or you are penalized and taxed). However, if you are already investing in a Roth IRA you can have it perform some double duty. If you’re not currently maxing out your Roth IRA (the 2010 limit is $5,000 per person) you can put your 529b investments into your Roth IRA instead. Keep doing this until you need money for education expenses, and then you can withdraw the principle back out of your Roth IRA, tax and penalty free. Let’s take two examples.
Option 1.
If you were invest $2,000 into your Roth IRA and $2,000 into a 529b every year, after 18 years of 8% returns, you’d end up with almost $81,000 in each account, with $36,000 of that being your original contributions (per account). This means there is about $45,000 in the 529b that has to be used for education, with $36,000 in the 529b that could be withdrawn and used however you’d like. If you end up only needing $30,000 in education expenses, you’ll have about $15,000 still in the 529b that can only be used for education, or it will be subject to the 10% penalty and taxation.
Option 2.
If you instead, put all that money into your Roth IRA, you’d end up with almost $162,000, with $72,000 of that being your original contributions. The total amount remains the same as in option 1, but the difference comes into play when you consider how much money you’ll end up needing for education. If you end up only needing $30,000 in education expenses, you can withdraw from your Roth IRA contributions, penalty and tax free, while leaving any excess in your retirement account.
What this gives you is some flexibility for the unknown cost of education in 18 years, as well as the other unknowns, such as scholarships, financial aid, or if your child will even attend college. Another bonus for option 2 is that 529b assets are counted against you when it comes to financial aid calculations, whereas your Roth IRA is not. Roth IRAs do have income restrictions though so if you want to use this methodology, start early (or never get raises).
To perform your own calculations you can use my Investment Calculator.
