529 Plan and College Savings

Archive for July, 2008

Question: Roth IRA vs mutual fund for additional college savings?

Currently I am saving for my daughter’s college savings using a 529 Plan in my state. I would also like to have an additional “savings” account for college for her. When she was first born she received a lot of gifts of money (maybe $500) in which I placed in a savings account (making 1% interest, woo hoo!). Anyway, over the last few years the account has grown to about $1000. So I decided to take the money out of savings to open the Vanguard Star fund($1K min. instead of $3K). So the Star mutual fund is in my name and I am planning to add to it as she receives monetary gifts (x-mas, birthdays etc). This money is stricly pegged for hercollege education but the downside is I have to pay the taxes on it every year. I do however want the peace of mind of knowing that if she doesn’t go to college that I won’t have to pay penalties like I would with the 529 Plan. So my question would a Roth IRA in my name be better than a mutual fund? If she doesn’t go then I can keep the $.

Answer: I don’t have a problem with the idea of supplementing the 529 savings with an additional investment in a mutual fund. Since you can own a mutual fund within a Roth IRA, the real question is really whether a Roth IRA will work for this particular purpose of funding your child’s college education.

The primary benefit of a Roth IRA is that investments held within it grow on a tax free basis AND you will not pay taxes on distributions of the appreciated capital from the Roth IRA so long as those distributions are “qualified distributions.”

What’s a qualified distribution?

To a qualified, the distribution MUST be 1.) made on or after the date YOU become age 59 1/2; OR 2.) made to your beneficiary, or to your estate, after you die; OR 3.) made to you after you become disabled within the definition of the IRS code; OR 4.) used to pay for qualified first-time home buyer expenses.

Plus, even if one of the qualifications above is met, the distribution is STILL not qualified if it is made within a five-tax-year period.

Well nothing prevents you from using funds from those distributions to pay for your child’s educational expenses, if you hope to reap the tax benefits of a Roth IRA you must stop making contributions five tax years prior to your child going to college and you must either be at least 59 1/2 years old, disabled, or dead.

Most people have their kids before age 40, and planning for a timely disability or death puts most folks off.

What I would suggest doing is sitting down with your tax adviser to see if you would be better off transferring the account from your name to that of your child. The tax ramifications may be less for them than it is for you. One draw back is that if the account appreciates significantly by the time your child turns 18 years of age, they may opt to use if for something other than college. It’s their money…

I have no input on your particular selection of fund, but Vangaurd is a fund family that I would be comfortable investing money with for myself or my family. I would suggest adding a second fund to the mix as that one fund appreciates, so as to provide some additional diversification once the assets become significant. You’ll also want to consider shifting assets to shorter term investments once your child reaches high school since you’ll want that money available in less than five years. I’d say by the time they are a high school senior you’ll want to be at least 25% in cash, with the rest in something very safe like T-Bills.

Good luck!

The Gift of the Michigan Education Savings Program