By: Investor Solutions, Inc.
The future can seem especially daunting for young families with all of the news about how expensive retirement will be, education cost that are spiraling upward and the myriad options that they should be taking advantage of. Let’s take a hypothetical couple we will call Tommy and Katy and see what challenges they may be facing and see what we can do to help.
Tommy and Katy are a hard working middle class couple who are anxiously awaiting the birth of their new baby girl. They have some money going into a 401(k), but nothing near the maximum contribution level because their biggest concern is making sure their little bundle of joy is on a straight path to college. Like a lot of couples, they feel college savings is a high priority and they will worry about retirement later on.
First of all, let’s determine how much our couple is going to have to come up with to put their future scholar through college. Let’s say Tommy and Katy live in Florida, so we will use good ole Florida State University as our example. Based on a current total cost of $11,838 per year and educational expenses increasing at 5% per year, they can expect to need the following by the time their daughter goes off to college:
Year 1: $28,490
Year 2: $29,914
Year 3: $31,410
Year 4: $32,980
Looking at these numbers AND the thought of retirement…they are probably envisioning what special talent will get their child a full scholarship. Not to fear, there is an alternative and it is in the form of a Roth IRA. But Tommy says, “I already told you that I will worry about retirement later.” Why not do both and here is what I mean.
Let us say Tommy and Katy set up Roth IRA’s for themselves and set aside $8,000/year and see what happens. Assuming an 8% return, Tommy and Katy will have contributed a total of $144,000 by the time their daughter is 18 and the account value will have grown to nearly $300,000. At that time, they take out the $122,794 for college and let the remainder grow to a whopping $1,000,000 by the time they are 65 (assuming they started at age 30 and made continued contributions).
Ok, that sounds great and all, but Tommy and Katy are not convinced and still have a lot of concerns:
What about taxes? This is an IRA; I must have to pay taxes.
The money you have in a Roth IRA falls into two categories: the contributions you’ve made to the account and the earnings on those contributions. Any regular annual contributions you make to a Roth can be pulled out tax-free at any time for any purpose. That make sense since Tommy and Katy made their contributions with after-tax dollars and thus they are only getting back money they already paid tax on. Please refer to IRS publication 590 for complete information on Roth distributions http://www.irs.gov/publications/p590/ch02.html.
What about financial aid? We make a modest living and may be strong candidates for financial aid.
In determining eligibility for federal financial aide, a Roth IRA is not counted as an asset of the student or the parent, but even the tax-free return of your Roth IRA contributions is treated as income in the financial aide formula. Although not ideal, it is still better than some of the other college saving tools. Below is how the various options fall with regards to the financial aide formula:
Greatest Reduction in Level of Aid
- Custodial Accounts (UGMA/UTMA)
- U.S. Savings Bonds, if issued in student’s name
- Traditional investments, if in student’s name
- 529 Savings Plans owned by parents
- Coverdell Education Savings Accounts with parent as “responsible individual”
- U.S. Savings Bonds owned by parents
- Traditional investments owned by parents
Smallest or No Reduction
- Retirement accounts held by student or parent
- 529 Savings Plans owned by grandparent or other person for the benefit of the student
- Direct tuition contribution, if someone else pays the student’s tuition. This has no effect on financial aid and is also fully exempt from any gift tax restrictions. (Caveat: Such a gift tax exclusion only applies to tuition payments, not payments for room and board.)
What if our daughter goes to Harvard? Then we have to double the tuition. Now what?
Although withdrawals of earnings are normally subject to a 10 percent penalty and regular income tax, the 10 percent penalty is waived if used to cover college expenses for yourself, your spouse or your kids. This would allow you to tap the whole $300,000 (minus income taxes).
In addition to their questions, I also point out the flexibility that comes with their Roth option. What if their daughter does in fact get a scholarship or their incomes allow for them to pay for college without tapping the Roth IRA In this fortuitous situation, Tommy and Katy have a sizeable amount already in the most tax advantaged place the IRS allows for. I also point out the fact that no one is going to be there to lend them money for their retirement, but they will lend their child money for college. We obviously don’t want that to happen, but financial missteps do occur.
All parents want the best for their children and a lot of parents are willing to forgo their own needs to insure their kids can go to college. With a little extra planning and the benefit of the Roth, parents can go a long way towards achieving both. Given the above example, Tommy and Katy were able to send their daughter off to Florida State University and have a million dollars left over for their retirement.