Saving for college? Try a Roth.
When it comes to saving money for college, many parents find themselves in a conundrum: They want to save for their children's education, yet they need to save for retirement at the same time.Skip to next paragraph
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While many financial experts advise making retirement saving the first priority, most parents still want to be able to pay at least part of their children's college costs. Thus, they often establish separate accounts: 401(k) plans to fund their own retirement and state-sponsored 529 plans to save for college.
But there's a third option families should consider adding to the savings mix, experts say: a Roth Individual Retirement Account.
"The Roth IRA has a lot of appeal for retirement and can be used for college, too," says Joseph Hurley, founder and chief executive of savingforcollege.com. The website specializes in providing information about 529 plans and other methods of saving for higher education.
"People should generally save for retirement first, because you can't get loans for retirement, and there are a lot of other sources of help available for college, including loans," Mr. Hurley says. In particular, 401(k) plans often come with matching contributions from employers.
But after retirement is covered, it's time to take a closer look at 529 college savings plans and Roth IRAs. Both plans use after-tax dollars for contributions, so you don't get a tax break up front but your earnings grow tax-free. Withdrawals from a 529 plan for education costs are tax-free, but so are withdrawals from a Roth IRA if the owner is over 59-1/2 and has had the account for over five years.
Even if you're younger, you can still withdraw your principal (not earnings) without penalty. "You can pull your contributions out at any time, for any purpose, without any taxes," says Mr. Hurley.
This flexibility is especially important if things don't go according to plan. In an era when many older workers are laid off before they reach retirement age, the Roth can serve as a pre-retirement cushion. Or it can add to retirement savings if a child gets a large scholarship or decides to forgo college completely.
Another important benefit of Roths: Many colleges don't count them - or any retirement savings - when they figure out how much parents can afford to pay. That's not true of 529 plans, which are considered parental assets and usually reduce the financial aid a student receives.
Roth IRAs have a drawback, however. Contributions are limited to $4,000 for 2005 ($4,500 for those over 50). So married couples would be able to save $8,000 per year toward their child's college education.
The 529 plans, by contrast, are much more liberal, points out Walter Herlihy, president of Beacon Financial Planning Inc., a fee-only firm in Centerville, Mass. Parents, grandparents - anyone - can contribute up to $11,000 ($22,000 for a married couple filing jointly) to each child without incurring federal gift tax.
Or a donor can contribute $55,000 in a single year ($110,000 for a married couple filing jointly) for each beneficiary as long as he or she doesn't make any other gifts to that beneficiary for five years, Mr. Herlihy says.