Saving in a Roth vs. 529 Plan

Was wondering which option is better?

1) Save for college in a Roth IRA and withdraw only the contributions (i.e. not interest on earnings) to pay for college.

or

2) Save for college in a 529 Plan and withdraw contributions and earnings to pay for college.

Some of the questions that impact the answer may be:

a) Are withdrawals (contributions only) from the Roth IRA counted as income on your taxes or counted as income in the financial aid process? (i.e. will it lower the financial aid package in the following year?)

b) Are withdrawals (contributions and earnings) from a 529 plan counted as income in your taxes or counted as income in the financial aid process? (i.e. will it lower the financial aid package in the following year?)

Let's start with your a) and b) questions first:

a) withdrawal of the contributions from a Roth IRA are not considered income for tax purposes, nor will they be counted as income in the financial aid process. The total Roth IRA account is a non-assessable asset, having no impact on the financial aid package.

b) withdrawal of the contributions and earnings from a 529 are not considered income for tax purposes (as long as the funds are used for qualified educational expenses). These overall account is considered a resource of the parent (much like other assets) for financial aid purposes, and therefore can impact the financial aid package for the following year. This impact is 5.6% assessment of 529 plan assets. In addition, the funds withdrawn are considered an income resource of the student, and therefore is assessed at 50%, impacting the following year's financial aid package.

While we're on the subject, the Coverdell ESA is considered an assessable asset of the child, which would have a significant impact on the financial aid package, since these assets are assessed at 100%. Withdrawals are considered resources of the child, assessed at 50%.

Now, on to your 1) and 2) questions:

1) & 2) It depends upon how much time there is between now and the distribution years, for one thing. If you have several years to contribute to your (and your spouse's) Roth, then it probably makes the most sense to start there, given your followup questions. However, for most folks, it makes great sense to use a combination of 529 plans, Roth IRAs, and Coverdell ESAs, planning the distributions of each in order to have the least amount of impact on the overall financial aid package.

Coverdell ESA should only make up a small amount of your savings, but the reason I've included it is because this plan can be used for a more liberal array of qualified expenses, most notably computing equipment and internet access.

The other accounts (Roth and 529) should make up the bulk of your college savings, but you'll likely want to use both types of accounts since the Roth is limited to $3k per year in contributions.

Although Mr. Blankenship has offered an extended there are two critical errors.

The less egregious one is his statement that CESA's are considered student assets. This was changed 8 months ago in a letter ruling by the DoE: http://www.ifap.ed.gov/dpcletters/GEN0402.html

More significant, however, is the statement concerning Roth IRA and financial aid. All withdrawals from an IRA - even the nontaxable withdrawals - are included as income for FA purposes. Refer to Worksheet B of the FAFSA.

This, of course, is what is current. FA guidance can always change, and it probably will.

Hope this helps.

TJ

The ROTH will protect the financial aid calculations as long as you don't use any of it the prior year.

You can hold protected assets in the Roth for the first 2 years of college and draw on it AFTER the first semester of the junior year and still maximize financial aid. In short, wait until the last year and a half to use it (you will not be claiming the income on the FAFSA if it is drawn on the last calendar year of awards).

Also, the 529 will lose it's advantageous tax treatment December 31st of 2010 unless the law is actually reviewed AND extended by Congress. If the law is not extended, all proceeds from growth will be taxed at normal income.
It's likely that the law will be extended given the popularity of the 529, but as of now, it ends in 2010. Something to be wary of.

Thanks to both of you, TJB_NC and pricespector, for the updates. This just goes to show that we should always seek a confirming second opinion, because rulings do change.