Tax Benefit of 529 vs. Flexibility of Roth IRA

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Topic Author
FS51
Posts: 49
Joined: Thu Sep 11, 2014 11:15 am

Tax Benefit of 529 vs. Flexibility of Roth IRA

Post by FS51 »

I'm hoping someone out there with a little more knowledge on the subject will be able to give some advice/opinion on my family's scenario and this investing question in general.

My wife is currently pregnant with our first child and I've been researching 529s a bit and have a quick question. I believe I understand many of the different opinions of a 529 vs maxing out retirement accounts first, however, I do have a quick question...

The wife and I are currently maxing our 401k's and we have Roth's that over the years we have contributed to but the last few years have put on hold and have not maxed out... Our state provides a state tax benefit of up to 10k for the two of us to contribute to a 529. I have a lump sum of say 10,000 that I'm looking to invest in either our Roth IRA's or a 529. Wouldn't it make more sense to take the tax deduction in the form of a 529 contribution as opposed to an after tax contribution to our Roth's? For reference, our MAGI does not allow us to contribute to a traditional IRA but does allow us to contribute the maximum to a Roth.

Also, the 529 in our state allows a tax deduction for anyone making a contribution, not just the account holder. Wouldn't opening a 529 make sense, if for no other reason but to give a tax advantage to our in-state relatives who would like to give birthday presents, holiday gifts, etc, in the form of college tuition as opposed to a toy?

Anyone have any strong opinions one way or the other?

Thanks in advance!
FS51
 
trueblueky
Posts: 1980
Joined: Tue May 27, 2014 3:50 pm

Re: Tax Benefit of 529 vs. Flexibility of Roth IRA

Post by trueblueky »

Scenario 1:
Fund 529, get state tax deduction, pay federal taxes
Later, use 529, pay no taxes on earnings

Scenario 2:
Add funds to Roth, pay federal and state taxes
Later, use Roth, pay no taxes on earnings

Financially, the only difference is the state tax deduction you can get now. We felt that the different time frames (college vs retirement) made a difference. You'll want a conservative AA in 529 as college approaches, but may still be years away from retirement.

Remember to pay $4,000 per year of tuition for four tax years (unfortunately, not the same as school years) from current income or from a taxable account to get the $2,500/year American Opportunity Tax Credit. You can't pay this from Roth or 529.
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The529guy
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Re: Tax Benefit of 529 vs. Flexibility of Roth IRA

Post by The529guy »

Hi, welcome! It seems I'm a slow writer and trueblueky beat me to it.

I'm going to assume you're currently 30s and you might tap into your Roth IRA in your 70s or later. Here's how I would look at it:

- If you do the Roth IRA, you pay state and federal tax now, but the $10,000 grows tax-free for 40+ years
- If you do the 529 plan, you pay federal tax now, but the $10,000 grows tax-free for ~20 years

Is the state tax avoided worth the extra 20+ years of tax-free growth lost? At the end of the day, that's the math problem at hand.
Also, the 529 in our state allows a tax deduction for anyone making a contribution, not just the account holder. Wouldn't opening a 529 make sense, if for no other reason but to give a tax advantage to our in-state relatives who would like to give birthday presents, holiday gifts, etc, in the form of college tuition as opposed to a toy?
This should not influence your decision. If you want to open an account for others' contributions, you can fund one with the minimum initial investment, which is hopefully low (e.g., $25 in NY).
Topic Author
FS51
Posts: 49
Joined: Thu Sep 11, 2014 11:15 am

Re: Tax Benefit of 529 vs. Flexibility of Roth IRA

Post by FS51 »

trueblueky wrote:
Remember to pay $4,000 per year of tuition for four tax years (unfortunately, not the same as school years) from current income or from a taxable account to get the $2,500/year American Opportunity Tax Credit. You can't pay this from Roth or 529.
Thank you very much for this!! I hadn't even stumbled across this yet as I was so focused on 529 pros and cons...
Ybsybs
Posts: 549
Joined: Thu Aug 28, 2014 4:28 pm

Re: Tax Benefit of 529 vs. Flexibility of Roth IRA

Post by Ybsybs »

I wrote out a comparison near this for someone else recently. It might help you too. This below compares using a taxable account to using Roth IRAs for educational savings. If you used a 529 instead of the taxable account, you would save on taxes but you would still have an undesired impact on the Expected Family Contribution (EFC).

Assumptions
(1) Example parents Abe & Bethany are eligible to contribute to both Roth IRAs and 401ks. Abe’s Roth IRA is Roth-A with a balance of $A past contributions and $GainsA now. Bethany’s Roth IRA is Roth-B with a balance of $B past contributions and $GainsB now.
(2) Example parents Abe & Bethany have budgeted $R+r per year for retirement savings and $E per year for educational savings.
(3) Example parents Abe & Bethany have exemplary kids Zoe & Yolanda.
(4) Example parent Abe has $(C+G) in a Roth IRA [$C contributions and $G gains] and money in a 401k. Example parent Bethany also has $(c+g) in a Roth IRA [$c contributions and $g gains] and money in a 401k.

Option 1:
$R added to 401k each year. $r added to Roth IRAs each year. $E added to taxable mutual fund and bond fund account each year.

16 years later:
$ 16*r + Gainsr + A + GainsA*16yrs + B + GainsB*16yrs = Total of Roth IRA accounts [Roth-A and Roth-B]
$ 16*R + GainsR = Total of 401k accounts
$ 16*E + GainsE - TaxesE = Total of taxable account funded for Zoe and Yolanda <-All of the account can be used on anything.

Grants offered to kids may be reduced Every Year by up to : ~12% of (16*E + GainsE - TaxesE)
If Parental Non-retirement Account Assets < Protected Allowance in 16 years, EFC isn't impacted at all. Also, if neither kid attends college in the US, EFC impacts again don't matter.

Option 2:
Abe and Bethany each start a new Roth IRA (which they call Roth-Z and Roth-Y even though Abe is the owner of Roth-Z and Bethany is the owner of Roth-Y).
$R+r added to 401k each year. $ 0.5*E added to Roth-Z and $ 0.5*E added to Roth-Y every year.

16 years later:
$ A + B + GainsA*16yrs + GainsB*16yrs = Total of Roth-A and Roth-B accounts
$ 16*(R+r) + GainsR + Gainsr = Total of 401k accounts
$ 16*E + GainsE = Total of Roth-Z and Roth-Y accounts

No TaxesE have been paid.
If Zoe and Yolanda need no educational funding, the money in Roth-Z and Roth-Y may be left to continue growing tax-free to pay for Abe and Bethany's retirement.
If the money is needed, 16*E is withdrawn (and noted in Abe & Bethany's taxes) and an amount of Roth contributions from Roth-A and Roth-B is withdrawn to equal GainsE (again noting these withdrawals in your taxes).
No reduction in Need-based support from the US Government or US colleges can be triggered by the $E savings and compounding of $E savings.

The same amount of total retirement money is present after educational funding withdrawals in Option 1 as in Option 2. Slightly more educational money is available in Option 2 than in Option 1. This additional amount is exactly the cost of paying TaxesE over the course of 16 years.

Option 2 doesn’t work if $ GainsE > $ (A + B), the contributions to Roth-A and Roth-B.
It also doesn’t work if $E is more than $11,000.
And it even more doesn’t work if there were other plans for $ (A + B) like using the contributions for a house downpayment.
And once more, Option 2 does work if $R+r > $17,500*2 + $5,500*2, or more specifically you are budgeted to max out your available retirement accounts for the purpose of funding your retirement. (This would not be at all a bad thing if you were, of course.)
Topic Author
FS51
Posts: 49
Joined: Thu Sep 11, 2014 11:15 am

Re: Tax Benefit of 529 vs. Flexibility of Roth IRA

Post by FS51 »

The529guy wrote:Hi, welcome! It seems I'm a slow writer and trueblueky beat me to it.

I'm going to assume you're currently 30s and you might tap into your Roth IRA in your 70s or later. Here's how I would look at it:

- If you do the Roth IRA, you pay state and federal tax now, but the $10,000 grows tax-free for 40+ years
- If you do the 529 plan, you pay federal tax now, but the $10,000 grows tax-free for ~20 years

Is the state tax avoided worth the extra 20+ years of tax-free growth lost? At the end of the day, that's the math problem at hand.
Also, the 529 in our state allows a tax deduction for anyone making a contribution, not just the account holder. Wouldn't opening a 529 make sense, if for no other reason but to give a tax advantage to our in-state relatives who would like to give birthday presents, holiday gifts, etc, in the form of college tuition as opposed to a toy?
This should not influence your decision. If you want to open an account for others' contributions, you can fund one with the minimum initial investment, which is hopefully low (e.g., $25 in NY).
Thank you! That makes a lot of sense. I guess while looking at this I wasn't just debating the 10k this year, but probably 10k each year allocated towards either/or. In terms of the gifts, you're absolutely right. I've been looking at this as IF I was going to open the 529. I should open one regardless just for that reason at the minimum even if I decide allocating towards the Roth makes more sense.

I think its pretty clear, I haven't been giving the extra time in the Roth enough consideration... Thank you!
Topic Author
FS51
Posts: 49
Joined: Thu Sep 11, 2014 11:15 am

Re: Tax Benefit of 529 vs. Flexibility of Roth IRA

Post by FS51 »

Ybsybs,

Thank you so much for the detailed response. I'm reading on my phone right now and have read through twice and while I do think I follow the variables and logic, I'm definitely going to need to re-read this tomorrow on a larger screen.

Thank you again for all of the insight. I will follow up again after I've had more time to digest lol 😄.

FS51
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