IRA or 529?

After my post last week (Higher Education Expenses Paid From an IRA) I received a question from a reader: “If it’s possible to pay QHEE from an IRA then why would it be beneficial to contribute to a 529 specifically?” In today’s post I’ll cover the reasons you might choose an IRA or 529 plan. These two types of account will help you prepare for the twin future requirements of retirement and college expenses.

As covered in the prior post, an IRA plan can be used in part to pay for college expenses. This is allowed in the Internal Revenue code, §72(t)(2)(E).

So why would you choose to place funds in an IRA or 529 plan? Specifically, why would the 529 plan ever be superior to an IRA for this saving activity?

Segregation

One reason a 529 plan might make sense is to specifically segregate your education saving activities from your retirement saving activities. The 529 plan is tax-advantaged only when you use the funds in it to pay for higher education expenses. So when you withdraw money from a 529 plan to pay for higher education expenses, there is no tax at all on the withdrawal.

This is also one of the drawbacks to the 529 plan: when you have money set aside in such a plan and you don’t use all of the money for education, there can be tax ramifications. If you withdraw your 529 funds for non-education purposes, you will owe tax on the growth that has occurred in the account. In addition to the tax, there will be a 10% penalty applied to the growth of the account.

So, for example, you have a 529 plan that has had $10,000 contributions over the years. The account has grown to $12,000 from investments. If you withdraw the entire $12,000 for non-educational uses, you will have to add $2,000 to your taxable income for the year. Plus you will owe a penalty of $200 (10% of the growth) for the non-educational withdrawal.

The contributions are never taxed, regardless of whether they are withdrawn for education purposes. But each withdrawal is pro-rated between contribution and growth. So in our example, if you withdrew $6,000 from the account for non-education purposes, tax and penalty would apply to $1,000 of the withdrawal.

In addition to the IRS taxation, there are likely penalties from your state (if you took advantage of the available state tax benefits discussed below).

State Tax Benefits

Many, but not all, states have a tax benefit available for contributions to a state-sponsored 529 plan, as a way to encourage participation. For example, in the state of Illinois you can deduct up to $10,000 ($20,000 for a married couple) from your Illinois taxable income each year. This can amount to a tax savings of $350 ($700 for marrieds).

On the downside, if you don’t have earned income – such as if you are retired – the tax deduction isn’t available against non-wage income. Plus, if you take your money out for a purpose other than for education, states often require that the previous tax credit (or deduction) is repaid.

On the other hand, depending on your state law, IRAs may have limited or no deductibility on your current state tax return (as in Illinios). However, regarding distributions, many states (like Illinois) do not include IRA distributions as taxable income, no matter when the distribution is made, for whatever reason.

Limitations on Contributions

IRAs have strict limits on annual contributions – for folks under age 50, the limit for 2017 is $5,500, for a total of $11,000 for a married couple ($1,000 more each if you’re over age 50). On the other hand, 529 plans have extremely high contribution limits – for example, the Illinois 529 plan BrightStart has an aggregate account limit of $350,000.

If you have a significant amount of money that you’d like to set aside specifically for education and you don’t want to slow-play contribute $5,500 (or even $11,000) per year, the 529 gets the money going in a tax-advantaged manner most effectively.

Flexibility

Each type of account, IRA or 529, has flexibility in its own unique way.

A 529 plan provides for tax-sheltered withdrawals for Qualified Higher Education Expenses, that’s a known quantity. But the 529 also allows withdrawals for some unique circumstances.

• You can withdraw a complementary amount when the student-beneficiary has received a scholarship.*
• You can withdraw the entire account penalty-free if the student dies or becomes disabled.*
• You can change the beneficiary of the account to (for example) a younger child or a grandchild if the original beneficiary didn’t use all of the funds.

* For the two starred options above, the growth in the account will be subject to ordinary income tax but no penalty would be applied.

An IRA has flexibility in that the funds can be used for any purpose at all after you’ve reached age 59½. Plus, as discussed in last week’s post, prior to age 59½ you could distribute IRA funds for education purposes without paying a penalty. The downside is that you will owe tax on every single penny – contributions (if deducted) plus the growth on the account, will be taxed.

IRA accounts generally have much more flexibility in your investments. 529 plans typically have a limited set of investment choices like a 401k plan, whereas the IRA needn’t be limited. You can choose a custodian that offers anything under the sun (within reason) as investment for your IRA.

Tax Deductibility

Above we covered the state deductibility of 529 contributions. From the IRS perspective, there is no deduction for 529 contributions. In that fashion, the 529 plan is similar to a Roth IRA – no deduction on contribution, but no tax on qualified withdrawals.

The IRA (traditional, not Roth) provides for deduction from your taxable income, within your overall income limits and annual contribution limits.

Conclusion – IRA or 529?

In the end result, my emailing friend poses a very good question – why would you choose between an IRA or 529? The primary arguments in favor of 529 plans are the contribution limit along with state tax benefits and segregation. Depending on your circumstances, these factors may be important enough to choose the 529. For most other circumstances, an IRA may be the better choice.

My professional advice is to consider the importance of segregation. Too often the short-term need of paying for education expenses is considered paramount against the long-term requirement for retirement education. When this happens, the parent who has raided his IRA to pay for junior’s education later often finds himself wishing he’d let junior get a student loan instead. By segregating education funds from retirement funds each account’s purpose is clear – helping you to be successful in your savings activities.