Maine Voices: Roth: A better college-savings plan?

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The after-tax IRA is more flexible, likely will grow faster than a 529 and can provide retirement security for parents.

DEDHAM, Mass. — The Harold Alfond Foundation recently announced an expansion of its college savings program. It now will give every baby born in Maine a $500 grant, which is invested in a 529 college savings account for future higher-education costs.

Sounds great, right? Who would say “no” to free money, especially when it’s for something as important as a child’s college education?

But along with the money, the Alfond Foundation – and the state of Maine, which administers the 529 savings program through the Finance Authority of Maine – should also give parents some free advice: The 529 savings account might not be the best option for college savings.

Disadvantages of 529 programs

As a professional financial adviser – and a father of “three under three” – I wouldn’t suggest a 529 college savings account as my first choice. Or second. That’s because, in my opinion, 529 programs have some distinct disadvantages over other investment options.

• Many 529s have high fees that really may not be justified given the alternatives out there. Parents should take a hard look at what they’ll be paying in administrative costs for 529s. (Fees for Maine’s 529 NextGen accounts are waived for Maine residents.)

• Withdrawals tend to be inflexible. In order for the withdrawals to be federally income tax-free, they can be used only for “qualified educational expenses.” If you use the money for something other than a college education – if your child decides against college, for example – you’ll be taxed on the earnings and pay a 10 percent penalty. Tax treatment at the state level may vary.

• A 529 plan tends to offer limited investment options and may not allow owners to adequately diversify their funds.

So if a 529 plan isn’t for everybody, what might be a better option?

How about a Roth IRA? A Roth IRA is primarily a retirement vehicle. You deposit after-tax money (just like a 529), and any earnings accumulate tax-deferred (just like a 529). When you reach age 59.5, your entire withdrawal is tax-free (provided you have owned the account for five years).

But there is a positive nuance to Roth IRAs that may not be widely known. You can always withdraw your regular contributions for any purpose without incurring taxes or penalties. Since your contributions were made with money that is already been taxed, you are allowed to withdraw these contributions (known as “basis”) anytime, tax-free.

Here’s a reasonable scenario:

You and your spouse begin contributing to your Roth IRAs (you can each have one, subject to income limits) after the birth of your first child. You each contribute $5,500 per year (the limit for 2014) until your child reaches 18.

If we assume an average annual return of the market at 8 percent, the combined account values would be roughly $445,000 – $198,000 of which (your contributions) would be available for you to withdraw (tax free). That’s more than enough to cover tuition and fees at the top colleges in the country.

If you were saving in a 529 plan, this withdrawal can only be used for college expenses. Otherwise, Internal Revenue Service taxes and penalties apply. Not so for your Roth contributions. Total flexibility. It is your already taxed money being returned to you.

And oh, don’t forget about the other $247,000. It keeps chugging away, and any earnings continue to accumulate until you decide to withdraw at retirement, tax free. Not a bad retirement/education vehicle.

More options, fewer drawbacks

You can open a Roth IRA virtually anywhere, and more importantly, you can invest in individual stocks, as well as most other traditional investments. And unlike a 529 plan, the balances in a parent’s Roth IRA are not considered an asset on the federal college financial aid forms – very important when calculating eligibility.

No question, it’s important to raise aspirations, especially in Maine, and encourage young people to get a college education. But it’s also important to educate students – and their parents – about sensible ways to save and invest, for college and retirement.

Speaking of which, here’s another tip: I wouldn’t suggest putting a dime toward saving for your kid’s college education until you have a secure retirement plan. Your child might never need a college savings account if there are grants and scholarships available, and even a loan isn’t the end of the world. But a retirement without any money kind of is.

— Special to the Telegram

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