Rethinking College Savings Strategies
Opportunities and Pitfalls in Integrating Retirement and College Savings

By Kevin Kobelsky and Brett Wilkinson

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In the authors’ view, a more effective approach for many individuals is to view college and retirement as two complementary objectives of an integrated savings program. Where individuals are not already maximizing contributions to a Roth IRA, doing so may have significant advantages over 529 plans and Coverdell ESAs.

Two recent legislative developments have considerable implications for the use of an integrated college savings–retirement strategy. First, the provisions for the new Roth 401(k) allow more individuals to increase the level of after-tax contributions that earn tax-free income. Despite the similarities between the Roth 401(k) and the Roth IRA, financial planners must be aware of the pitfalls of assuming the two vehicles are interchangeable for college savings purposes. Second, recent legislation permits the conversion of traditional IRA balances to Roth IRA balances, irrespective of the taxpayer’s adjusted gross income (AGI), beginning in 2010. This creates a means for high-income individuals to enjoy the benefits of a Roth IRA.

Integrated Savings Strategy

In preparing for both retirement and college expenses, individuals face a vast array of tax-favored savings options. (As well as tax deductions and credits for tuition and fees. Although it is best to take advantage of all such options, financial constraints may make this impossible. In this situation, attention should be given to the order in which the different vehicles are used. For example, if a married couple with one child is able to save $5,000 per year, how should it be allocated among retirement and college savings options? Although individuals typically consider retirement and college savings as separate and conflicting goals, provisions within IRAs enable them to serve a dual role.

Some financial advisors might be concerned about the merit of using retirement savings vehicles for college savings. Without clear boundaries between retirement and college funds, clients may be tempted to withdraw more funds for education than is prudent. These concerns are legitimate; however, this can be managed through the use of separate IRA accounts for education and retirement. For individuals who are not in a position to increase aggregate savings and are not fully using available retirement savings vehicles (that is, most taxpayers), blending retirement and college savings may prove more beneficial than treating the two savings goals independently. For these taxpayers, relying solely on a traditional college savings vehicle (e.g., a 529 plan or Coverdell ESA) is not necessarily the best choice.

Determining whether an IRA should be part of a taxpayer’s savings strategy requires weighing three factors: tax minimization, flexibility in case financial needs change, and access to federal and college grants (see the Sidebar “College Grant Aid”). A brief overview of the major tax-favored saving vehicles follows below, along with a discussion of the settings in which each is preferred.

Traditional Savings Vehicles

Traditional and Roth IRAs. Individuals are permitted to make contributions of up to $4,000 ($5,000 for 2008) to a traditional IRA or to a Roth IRA (subject to AGI limitations). From 2009 onward, the contribution limits will be indexed for inflation and adjusted in $500 increments.

The benefit of a traditional IRA from the college savings perspective is that funds can be withdrawn as needed for qualifying higher education expenses. These early withdrawals do not incur the 10% penalty that would otherwise apply. Funds not needed remain tax-sheltered until withdrawn in retirement. Thus, individuals reduce current tax (through deductible contributions) and earn tax-deferred income but have the flexibility of withdrawing contributions and earnings for college purposes without a penalty. Income tax is, however, levied on the entire withdrawal.

A benefit of the Roth IRA is that contributions are made with after-tax dollars. This increases the amount of funds that can be shielded from income tax from an integrated retirement and college savings perspective. Contributions can be withdrawn tax-free for higher education at any time; however, in contrast to a traditional IRA, earnings in a Roth plan withdrawn before age 59 Qs will be subject to income tax, and should be left for retirement. While a Roth IRA does not allow earnings to be accessed for college, it does allow more funds to be shielded from taxation. If individuals have funds available to save for college or retirement in excess of the pretax traditional IRA contribution limit (to cover the additional up-front income tax), using a Roth IRA would be beneficial.

Neither Roth nor traditional IRA balances are taken into consideration when determining financial aid. Current distributions, however, are included as parental income, regardless of income tax treatment, and reduce grant aid by an equal amount. As a result, Roth withdrawals hold an advantage over traditional IRA withdrawals, because a much larger amount (with a correspondingly larger impact on aid) must be withdrawn from a pretax traditional IRA in order to fund the same college costs.

Coverdell ESAs and 529 plans. Like the Roth IRA, contributions to a Coverdell ESA are nondeductible. Up to $2,000 per beneficiary may be contributed each year. Like the Roth, eligibility is constrained by AGI. Earnings are tax-deferred and ultimately distributed tax-free if the distributions do not exceed an individual’s qualified education expenses (which include elementary, secondary, and higher education expenses).

A 529 plan (also known as a qualified tuition program) permits contributions from after-tax income, with earnings remaining tax-free to the extent that distributions are used for higher education expenses. Unlike a Coverdell ESA, contributions are not limited and the ability to contribute is not constrained by AGI.

One significant disadvantage of both a Coverdell ESA and a 529 plan is that, to the extent that distributions exceed the qualified education expenses of the beneficiary, earnings are subject to both income tax and a 10% penalty. The penalty can be avoided if the student receives another form of tax-free educational assistance, such as a scholarship or employer-provided educational assistance. The income tax on the earnings of the plan cannot be avoided, however, imposing significant and unexpected additional tax costs. Unlike the case with a Roth IRA, where unused funds are left in the account to grow tax-free for retirement, funds in a Coverdell ESA or 529 plan that are not used for educational purposes may incur a substantial tax cost. A potential mitigating factor is that unused funds may be accessed by different family members, by changing the designated beneficiary or by rolling over the funds to another beneficiary (beneficiaries must be members of the same family).

The Coverdell ESA has a significant disadvantage as compared to an IRA in determining grant aid. If a student child is the owner of the ESA (as is generally the case), it is considered the child’s asset, and current grant aid is reduced by 20% of the balance in the account. In contrast, an IRA is considered a parental asset, which reduces grant aid by a maximum of 5.64%. A 529 plan holds an advantage over the Roth IRA for grant aid purposes: The balance in the account is included in parental assets, and distributions are not included in student or parental income.

Prioritizing Savings Vehicles: Case Studies

If an individual lacks the resources to take full advantage of all savings opportunities, the order in which they are used becomes important. Although every savings plan needs to be tailored to individual circumstances, the three key variables affecting college savings planning are income, the number of dependents attending college, and the preference for private versus public education.

Four different scenarios, with taxpayers in various AGI ranges, are illustrated below. They illustrate how advisors can use these variables to help taxpayers establish a flexible and integrated savings strategy that balances retirement and college savings goals. A summary of the optimal savings mix for different AGI scenarios is provided in the Exhibit. In all cases, it is assumed that an individual would contribute to a 401(k) up to the level of any employer match, because the benefits of the match outweigh the benefits discussed here. Beyond that point, the optimal savings strategy varies with the client’s income level and the total cost of education (see the Exhibit).

Case 1: Alan and Susan Jones

Alan and Susan Jones have an AGI of less than $55,000 and have two children (ages 3 and 1). Three-quarters of all filers nationwide fall into this AGI range. At this AGI, federal and private college need-based grant aid is likely to be available. If Alan and Susan have assets (other than their retirement savings and primary residence) of less than $60,000 when their children attend college, then each child will qualify for grant aid of $4,310 or more per year (see the Sidebar “College Grant Aid”).

Because of the grant aid their children will likely receive, the Joneses should use a 529 plan, because it has the least negative effect on grant aid. The potential cost of having 529 funds in excess of higher education expenses (and thus incurring income tax and a penalty) is outweighed by the potential cost of losing grant aid.

The Joneses’ AGI is too high for them to be eligible for the retirement saver’s credit. If it were not, the credit benefit (up to $2,000) might outweigh the benefit of grant aid and a 529 plan.

Case 2: Cassandra and Peter McNamara

The McNamaras have two children, Kelly and Robert, and a total AGI of $65,000. Because of their AGI, the McNamaras face a phaseout of college grant aid. They could use their IRAs to cover college expenses, but this accelerates the grant aid phaseout and reduces the chance of obtaining grant aid. Alternatively, they could save through a 529 plan and run the risk of incurring a penalty if the 529 funds are not used for higher education expenses.

The McNamaras must balance the risk of losing college aid against the risk of a tax penalty from having 529 funds that exceed actual expenses. The grant aid phaseout and the likelihood that their incomes and assets will increase over time make it unlikely that their children will be eligible for grant aid, favoring the use of a Roth IRA.

Case 3: Kara and Rick Ryan

Kara and Rick Ryan have two daughters and an AGI of $110,000. Need-based grant aid will not be available to them because of their AGI. Accordingly, they are ideal candidates for adopting an integrated retirement and college savings strategy using Roth savings plans. How this is implemented depends largely on the choice between private and public education. If their daughters attend a public university, the Ryans can fund virtually the entire cost of college by withdrawing their Roth IRA contributions tax- and penalty-free. This would leave their Roth IRA earnings intact to grow for retirement. This option is also highly flexible: Funds that are not needed for college (for example, due to scholarships) remain in the account for retirement. Individuals in this AGI range should fully fund their Roth IRA before contributing to a 529 plan.

The advantage of after-tax contributions to the Roth IRA becomes particularly apparent in this case. The Roth IRA contributions will fund all but $2,000 of the Ryan daughters’ expenses at a public university, and leave a $225,000 tax-free balance to grow for retirement. If, however, these contributions were made to a traditional IRA and the tax refund invested in an after-tax account, the Ryans would have a taxable balance of $284,000 available for retirement after paying college expenses, equivalent to a $199,000 tax-free balance (assuming a 30% marginal tax rate).

If the children attend a private university, the parents’ Roth contributions will not be sufficient. To fund the shortfall, the family has several options. Drawing upon the Roth earnings should be avoided, because this would be treated as taxable income, resulting in a high tax cost. The Ryans could instead use a 529 plan to supplement the Roth IRA because both contributions and earnings can be withdrawn tax-free. When paying for college, the 529 plan contributions and earnings should be withdrawn before any Roth contributions, because unused 529 funds incur a 10% penalty. If the Ryans establish a 529 plan for each daughter, excess balances in one account can be used to fund the educational expenses of the other child.

If either Rick or Kara has a traditional IRA balance or a 401(k) plan from a previous employer, they have an even more attractive option: converting it to a Roth IRA. This will allow otherwise inaccessible funds to be made available for college expenses (see Sidebar “Tapping a 401(k) for College Expenses”).

Case 4: Robert and Amanda Ford

The Fords have two children and an AGI of $200,000. Taxpayers with an AGI exceeding $160,000 cannot contribute to a Roth IRA at all and cannot contribute to a deductible traditional IRA if they are also covered by an employer plan. They can contribute to a nondeductible traditional IRA. Earnings accumulate tax-free; unlike a Roth IRA, however, they are taxed upon withdrawal. Under current legislation, traditional IRAs may be converted to Roth IRAs regardless of income level, beginning in 2010. This loophole permits individuals to effectively avoid the AGI limitation for Roth contributions by contributing to a nondeductible IRA and immediately converting it to a Roth IRA. If the law remains unchanged, the Fords can follow the same strategy as the Ryans (Case 3) by using a two-step procedure: Each year after 2009 they may contribute to a nondeductible traditional IRA and immediately convert the balances to Roth IRAs.

If this loophole is closed before 2010, the Fords could continue to contribute to a nondeductible IRA and then withdraw contributions to pay for college expenses. The taxable pro rata earnings portion associated with the withdrawal can be rolled into another IRA without penalty. The amounts contributed and available for funding are identical to those for the Roth IRA, with the important difference that the earnings left for retirement are subject to income tax when withdrawn.

If it is assumed that this tax loophole will close (and thus immediate annual conversion to a Roth is not available), the Fords should weigh the benefits of a nondeductible IRA against a 529 plan. Nondeductible IRA earnings incur income tax, although it is deferred until withdrawal in retirement. The 529 plan earnings incur no tax if used for educational expenses, but earnings not used for college expenses incur income tax plus a 10% penalty. In this case, a mix may be most effective to manage risk: 529 plans for at least the minimum expenses expected, and a nondeductible IRA for the balance.

As with the Ryans (Case 3), if the Fords have a balance in a traditional IRA or a previous employer’s 401(k) plan, it can be converted to a Roth IRA (see Sidebar “Tapping a 401(k) for College Expenses”).

The above scenarios provide some general illustrations of the ways that college and retirement savings can be integrated to achieve greater flexibility and beneficial tax outcomes. The Exhibit summarizes the strategies that financial advisors might recommend based upon taxpayers’ varying levels of AGI and anticipated college expenses.

New Roth 401(k) Plans: Opportunities and Pitfalls

The Roth 401(k) plan was made permanent by the Pension Protection Act of 2006. The law permits retirement plans to offer a 401(k) savings vehicle that operates along the same lines as a Roth IRA: nondeductible contributions with tax-free distributions. Unlike the Roth IRA, participation is not restricted by AGI, and contribution limits are the same as regular 401(k) plans ($15,500 in 2007).

Given the advantages of the Roth IRA as a dual college-retirement savings vehicle, one might presume that the new Roth 401(k) creates new college savings opportunities by making more taxpayers eligible for Roth-like plan benefits, and increasing the amount that can be contributed to plans for those already eligible. At present, however, this is not the case. There are two key areas in which the proposed Treasury Regulations for Roth 401(k)s diverge from the regulations for Roth IRAs and create substantial problems in using Roth 401(k) plans as integrated retirement–college savings vehicles.

First, distributions from a Roth 401(k) to fund higher education expenses are only allowable as a “hardship” distribution. The earnings portion of any such distribution prior to age 59 Qs would be subject to both income tax and an additional 10% penalty. One way around this would be to withdraw only contributions, because they are made on an after-tax basis and thus reflect a recovery of basis with no tax cost. This highlights the second key difference between the Roth 401(k) and Roth IRA: While Roth IRA distributions come first from contributions and then from earnings, the proposed Roth 401(k) regulations require distributions to be allocated to contributions and earnings pro rata. This is ironic, because even though total hardship distributions are limited to the amount contributed, the distribution itself is characterized as a mix of contributions and earnings. Furthermore, hardship distributions do not qualify for a rollover, making it impossible to avoid the tax and penalty on earnings by rolling the earnings component of the distribution into an IRA.

Workers who change employers can avoid these problems by rolling a Roth 401(k) into a Roth IRA. At any time after severing employment, individuals with an AGI below $100,000 can roll traditional 401(k) plan savings into an IRA and convert them to a Roth IRA, making the contributions available to fund college expenses. As mentioned above, taxpayers above this AGI limit must wait until 2010, when the limit is scheduled to be eliminated.

If the final regulations were to be revised to be consistent with those for Roth IRAs, long-serving employees would also enjoy these benefits, dramatically enhancing the value of the Roth 401(k).

Roth 401(k) plans are also effective for taxpayers who will be over 59 Qs when retirement funds are needed to pay college expenses. After this age, of course, funds can be accessed without penalty, providing an attractive vehicle for grandparents to assist their grandchildren with college costs.

©2009 The New York State Society of CPAs. Legal Notices