Young adults who start their careers weighed down by college debt have a tough time buying a home or initiating a retirement savings plan. That’s why, in 1996, Congress added Section 529 to the Internal Revenue Code, creating a new tax-advantaged college saving vehicle. More than two decades later, “529 plans” now collectively hold around $320 billion in assets.
A lesser-known alternative, with its own set of pros and cons, is the custodial Roth IRA. Even if you’ve already started a 529 plan, it might be worthwhile to also consider a custodial Roth IRA.

Given the cost of higher education these days, every extra dollar that can be saved for future tuition bills counts. That means if you don’t have to spend a slice of the investment returns on college (or retirement) savings, you come out ahead, and so does the child, indirectly.

How far ahead you’ll get depends on the length of time involved, and how much of the investment return is from interest income versus capital gains and stock dividends. Remember that interest income is taxed at the same rate as “ordinary” income like a salary, while “qualified” dividends and capital gains are taxed at lower rates.

529 College Savings Plans

With 529 plans, the basic rule is that there will be no taxes owed on investment earnings while those dollars are in the plan, or when they are distributed, as long as they’re used for qualified education expenses. This includes tuition, textbooks and supplies. Room and board that are part of an official college or university housing program also qualify.

If 529 plan distributions are used for nonqualified expenses, the child whose name is on the account must pay income tax plus a 10% penalty on the amount of that distribution. Chances are that the child won’t be in a high tax bracket at that time, so the bill might not be terribly onerous. Still, it’s better to avoid taking that hit.

Custodial Roth IRAs

You may already be familiar with the concept of a Roth IRA. A custodial Roth IRA is established and managed by an adult (typically a parent or grandparent) for the benefit of a minor. When the child is no longer a minor, he or she assumes full control of the IRA.

On the plus side, early distributions (generally defined as prior to age 59½) from a custodial Roth IRA are considered first to originate from the contributions to the plan, and aren’t taxable. With a couple of exceptions, money taken out of a Roth IRA after age 59½ isn’t taxable. That’s important as it relates to using a custodial Roth IRA as a college savings vehicle.

Suppose, for example, you’ve contributed $75,000 over the course of several years, and the value of the account has grown to $125,000. The IRA’s beneficiary could take out up to $75,000 to pay for college (or, for that matter, any other) expenses without incurring a tax liability. The remaining $50,000 could continue to grow tax-free as long as those funds are left in the account. And, thanks to the Roth format, the funds could be withdrawn when the child reaches age 59½ without being taxed. Tax-free distributions are also allowed without taxation for account owners under 59½ if they’re permanently disabled, or they use up to $10,000 for a first-time home purchase.

Contribution Limits

An important caveat about the custodial Roth IRA is that no more can be contributed to it in any year than the child has in earned income during that year. It’s the same rule that applies to all IRAs. However, the child doesn’t have to receive the kind of income that’s reported on a W-2 or 1099 tax form. Informal but compensated jobs, such as babysitting, dog-walking and lawn care services count, too, though you’ll need to maintain a careful record of those earnings.

In 2019, the maximum annual contribution to an IRA is $6,000 for people under age 50. So, if the custodial Roth IRA beneficiary earns, for example, $4,000 in 2019, you could make a gift to the child in that amount to be used to fund the IRA. Of course, the child could also use some of his or her earnings to hit that $4,000 annual maximum and get an important early lesson on the value of having a long-term savings plan.

As a practical matter, the amount you can contribute to a 529 college savings plan without tax consequences is unlimited. Those contributions are treated as gifts, and you and your spouse can each give up to $15,000 a year to as many people as you want before you start eating into your lifetime annual gift tax exclusion amount. And even then, there might be no tax consequence unless, when you die, you have exhausted your lifetime estate tax credit and some portion of your estate is taxed.

One More Thing

Whatever college funding path you choose, look at the big picture. Besides the tax considerations, it’s also important to know whether your chosen gifting strategy will impact the child’s eligibility for financial aid. Consult your financial advisor to ensure you understand your options and have the information you need to make the best decision for your family.

© 2019