Paying For College Part II: I Want My Kids To Go…But Can We Really Afford That?
In the first installment of this series, we met Will, Dianne, and Candice. They have been looking into the various possibilities to pay for Candice's college education. If you did not have a chance to read Part I, feel free to catch up with the breakdown of federal funding sources. After looking into all of the various federal funding sources, Will and Dianne decided that they wanted to explore their options for contributing more of their own money from their salary and savings to Candice's college education.
As referenced in Part I, the How America Pays for College reports, college education costs were covered by the six distinct funding sources depicted below.
Sallie Mae. (2021). (rep.). How America Pays for College. Retrieved from https://www.salliemae.com/content/dam/slm/writtencontent/Research/HowAmericaPaysforCollege2021.pdf.
While Will and Dianne may not be able to pay for 100% of Candice's college education costs from income and savings alone, they also have a 10-year-old son named Elliott. They would like to be knowledgeable of all the available options for funding their children’s future education.
In their research, Will and Dianne came across various options, as detailed below.
529 College Savings Plan
A 529 College Savings Plan is a tax-advantaged savings vehicle that families can use for qualified education expenses. The withdrawals are tax-free if the disbursements are used only for qualified education expenses. These expenses include tuition and fees, room and board on and off-campus, food and meal plans, etc. If funds from a 529 College Savings Plan are withdrawn and used for non-qualified education expenses, the earnings portion of the distribution is subject to a 10% withdrawal penalty.
Pros:
Contributions are made after-tax, and earnings can be withdrawn tax-free when used for qualified education expenses.
The contribution portion of the account will never be taxed or penalized due to the after-tax contribution status.
Contributions may be partially or fully deductible from state taxes.
Cons:
Funding can only be used for qualified education expenses. Earning incur penalties when distributed for non-qualified expenses.
Roth IRA
A Roth Individual Retirement Account (IRA) can be established as a combination of a retirement account and education savings account, which provides greater flexibility than a 529 College Savings Plan. Similar to a 529 plan, though, Roth IRAs consist of after-tax contributions that grow tax-free. Penalty-free withdrawals are allowed from Roth IRA accounts when used for qualified education expenses.
Pros:
Contributions are made after-tax, and earnings can be withdrawn tax-free when used for qualified education expenses.
The contribution portion of the account will never be taxed or penalized due to the after-tax contribution status.
The account serves a dual purpose as a retirement vehicle and is not strictly reserved for education expenses.
Cons:
Funding is generally included as income when determining financial aid eligibility which may reduce the total funding available from need-based and non-need-based federal aid and scholarships.
Contribution amounts are limited to the annual cap ($6,000 in 2022).
Withdrawals from a Roth IRA for education expenses can negatively impact retirement savings plans if not adequately planned.
While withdrawals for education expenses are not subject to an early withdrawal penalty, the earnings portion of such withdrawals is still subject to federal income tax.
Coverdell Education Savings Accounts (ESAs)
Education Savings Accounts (ESAs) are closely related to 529 College Savings Accounts. Qualified withdrawals are tax-free, but contributions are limited to $2,000 per year until the beneficiary's 18th birthday. One distinct difference from a 529 plan is the flexibility to use funds on education expenses from kindergarten through graduate school.
Pros:
Contributions are made after-tax, and earnings can be withdrawn tax-free when used for qualified education expenses.
Cons:
All assets must be distributed to the beneficiary by the age of 30.
After reviewing the tax-advantaged income and savings options, Will and Dianne want to continue exploring any other available sources to cover Candice's higher education costs. We will continue our deep dive in Paying for College Part III.