College Savings Strategies
Opportunities and Pitfalls
in Integrating Retirement and College Savings
Kobelsky and Brett Wilkinson
SEPTEMBER 2007 - With
rapidly increasing college costs, the need for a carefully developed
college savings strategy has never been greater. According to
the College Board, the average annual cost of a four-year public
college exceeds $12,000 and that of a four-year private college
is approaching $30,000. In many cases, advance planning and the
use of tax-favored savings vehicles can minimize the need for
borrowing in order to fund college costs. IRC section 529 savings
plans and Coverdell Education Savings Accounts (ESA) are popular
but are often viewed in isolation from an individual’s retirement
savings strategy. For all families, but especially those raising
children later in life, this can be a heart-wrenching tradeoff.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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
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.
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).
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.
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.
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).
1: Alan and Susan Jones
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”).
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
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.
2: Cassandra and Peter McNamara
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.
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.
3: Kara and Rick Ryan
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.
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.
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”).
4: Robert and Amanda Ford
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
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
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
Roth 401(k) Plans: Opportunities and Pitfalls
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).
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
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.
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).
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.
Kobelsky, PhD, CISA, CA, is an assistant professor and
Brett Wilkinson, PhD, is an assistant professor
and the Roderick L. Holmes Chair of Accountancy, both at the Hankamer
School of Business, Baylor University, Waco, Texas.