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Retirement Perspectives

If you’re looking for maximum flexibility, consider setting up a Roth IRA to defray your children’s higher education expenses.

Of the many financial challenges facing parents today, saving for and paying for their children’s college education ranks at the top of the list. As the most recent survey of college pricing by the College Board revealed, a moderate college budget for an in-state public college for the 2017/2018 academic year averaged $25,290, while a private college averaged $50,900. No wonder some families fear that they won’t be able to afford an education for their child or that they may have to work much longer to foot those bills.

Although the rising costs of tuition, room and board, and fees may seem daunting (even with financial aid), the relatively good news is that there are a variety of tax-advantaged vehicles (e.g., 529 savings plan, Coverdell Educational Savings Account) to help American families save for future educational costs, including the use of a Roth IRA.

Generally, taking a distribution from an IRA before age 59½ is subject to federal income tax plus a 10% early distribution penalty. However, if you are considering using your IRA (including SEP and SIMPLE) to pay for a portion or all of your children’s higher education, there is an exception to the early distribution penalty: the education-expense exception. The exception does not, however, apply to distributions from a qualified plan such as a 401(k), 403(b), 457, etc. If you’re eligible for a 401(k) distribution, funds can be rolled into an IRA and then distributed in order to qualify for the education-expense exception.

The education expenses can be for you (the IRA owner), a spouse, children, or grandchildren. Further, eligibility doesn’t require children to be claimed as a dependent on your tax return. There is no maximum amount of funds you can distribute from your IRA. This means that you can take penalty-free distributions—and as much as needed—from your IRA to pay for college tuition (and fees, room and board, etc.), a computer, or other educated-related expenses for a child and or grandchild.

Tip: To qualify for the exception, the expense and IRA distribution must take place in the same tax year. In other words, the educational expense must be paid in the same calendar year as the IRA distribution was taken.

What Is an Eligible Education Institution?
The IRS defines an eligible educational institution as “any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions.” The definition includes virtually all accredited public and private post-secondary schools. Any scholarship(s) received would reduce the amount of IRA distributions that you are eligible to take without being assessed the 10% penalty.  K-12 expenses would not be covered.

Tip: The Tax Cuts and Jobs Act of 2017 gives parents who enroll their children in private school (elementary and high school) additional tax-advantaged savings options. Currently, a Coverdell Education Savings Account (ESA) is the only savings vehicle that offered the potential for tax-free withdrawals to pay for K-12 expenses. The bill includes a welcome provision expanding qualified tax-free 529 plans withdrawals up to $10,000 per year to pay for K-12 expenses, giving more families an opportunity to save tax-free for private, public and religious schools.

529s versus Roth IRAs
The primary purpose of a 529 plan is to receive tax-free distributions for a variety of qualified education expenses, but a Roth IRA often provides the same tax benefits—with greater flexibility. As a result, a Roth IRA may be a  the better savings vehicle for college funding, for the following reasons: flexibility, access to funds, and its (lack of) impact on financial-aid calculations. Finally, Roth IRAs offer parents and/ or grandparents  the opportunity to save for both higher eduation  and retirement concurrently.

Flexibility
Roth IRA contributions can be distributed at any age, at any time, regardless of a holding period, free of income tax and penalty. Put another way, your principal is (always) available for distribution, tax and penalty free. However, Roth conversion distribution rules differ. Amounts converted to a Roth IRA may also be distributed without being subject to income tax and or penalties, even if you’re under age 59½, as long as the conversion occurred at least five years ago. Investors taking a  distribution before age 59½ within five years of the conversion would face a 10% penalty tax known as a “recapture tax.”

Retirement Accounts and FAFSA
Parents of college-age students are all too familiar that applying for student aid generally requires the filing of a Free Application for Federal Student Aid (FAFSA). Less obvious, and often misunderstood is the fact that retirement accounts, including Roth IRAs may be excluded from your assets. Although there are exceptions, some higher education institutions do take parents’ retirement funds into account. Notably, the FAFSA application also includes questions regarding income, which can be increased when you take distributions from your retirement accounts and or make Roth conversions.  

Similar to saving for retirement, parents should to start saving for their children’s college education as early as possible. 

But, suppose your child decides not to go to college. What would happen to your 529 account that you specifically established to cover education expenses? You would be subject to income tax on any gains and assessed a 10% penalty.

As long as 529 distributions are used to pay the expenses for qualified higher education, distributions are tax-free; whereas for a Roth IRA, they are tax-free regardless of how or where the funds are used.

Roth IRAs are a powerful tax-advantaged vehicle for retirement and or college savings; however, they are not a panacea. For example, income limits prevent higher income earners from contributing; unlike some 529 plans, you never receive a tax deduction for making a contribution. Many states also offer tax deductions, or tax credits, for 529 contributions. The annual contribution limit for the 529 plan is $15,000 ($30,000 for married couples). without an income test, compared with $5,500 (2018) for Roth IRAs.

If you have any questions about this or another retirement topic, please e-mail me at roadtoretirement@lordabbett.com.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY OF TERMS

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP IRA.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. 529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.

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