If you have children and are following this blog series, there is a good chance you are actively planning to send your child (or children) to a college or university. Finding ways to save for college can be daunting but if you work at it, you can find not only ways to fund their education but also save you money while doing it – especially if you are a business owner.
How? Hire your kids as employees. That’s right, put them on the payroll and rollover any earnings into a Roth IRA, up to the 2015 maximum of $5,500. (Another, more complicated option not covered in this blog, is to set-up and use the Employer Education Assistance program to provide up to $5,250 per year tax-free to any of your employees that are attending college.)
There are several benefits in taking this approach to college savings.
- Paying your children a salary lowers your overall income. This in-turn lowers your overall tax bill.
- Your child will be in a lower tax bracket because their earned income will be much lower than yours. They in-turn will pay much less in taxes, if they pay any taxes at all.
- Your child gets a jump start on retirement savings …. And the money can be used to pay for college expenses. Many parents don’t know this, but withdrawals from IRA’s can be used for qualified educational expenses, including tuition, fees, books, and room and board, penalty free.
- As a kicker, you can continue to claim them as a dependent on your tax return.
Does this sound too good to be true? Let’s be clear, the money that is earned must be for legitimate work in support of the business. If you have a home based business and you put your kid to work washing the dishes or mowing the grass, the IRS will come knocking on your door. (Now … if you can get them a job with a lawn servicing company, then it is legitimate earned income and they can put the money in an IRA to use for their education expenses or save for retirement!!).
529 vs Roth or Traditional IRA …
So what about opening a 529 plan and moving their earnings into it?
A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. They are legally known as “qualified tuition plans” and are sponsored by states or educational institutions. You can open and fund a 529 before a child is born. If you are “the perfect planner”, you could open an account a decade or more before your child is born and reap the benefits of compounding. To do this, you must make yourself the beneficiary. Once your child is of age, then you can make them the beneficiary. As long as you are absolutely certain your child (or one of your children) will be going to college, then start contributing to a 529 account immediately.
However, if you are not sure your child will go to college or were late in planning for college then contributing to an IRA will give you more flexibility and better tax treatment than a 529 alone.
The main drawbacks to a 529 …. Money saved in a 529 can only be used to cover the costs associated with college. If your child ends up not going to college, then you cannot transfer the beneficiary to another person other than a relative of the original beneficiary. Also, if the money is tapped for anything other than education, it is taxed and subject to a 10 percent penalty. A final consideration is that 529 plan balances are used in determining Expected Family Contribution (EFC) which could impact the amount of financial aid you might receive.
Roth and Traditional IRA …
On the other hand, Roth and Traditional IRA’s, which were originally designed to be retirement accounts, allow a person to set aside after-tax (Roth) or before-tax (Traditional) income, up to a specified amount each year. For the Roth, all withdrawals after the age of 59 ½ are tax free. Since Traditional IRA’s were funded with before-tax contributions, taxes are taken out when they are withdrawn.
Being able to tap a retirement account for other uses, such as paying education expenses or buying a house, came later. This is what gives IRA’s somewhat more flexibility than s 529 plan. Hold the money until retirement or use it for paying qualified education expenses. Another bonus, assets held in retirement accounts are not used in the EFC calculation so there should not be any impact on how much financial aid you receive. Be warned though, while the assets held in the IRA’s do not count in the EFC calculation, any distributions from these accounts will be counted as untaxed income and will be used in the EFC calculation. Also, prior year’s contributions do get counted as untaxed income and are counted.
So, which IRA option is best? A Roth IRA.
For a Roth IRA:
- There are no immediate tax benefits but,
- Contributions that are withdrawn for qualified education expenses are tax free, since these funds have already been taxed and,
- If the money is kept until retirement, distributions are tax free
For the Traditional IRA:
- The tax benefit of deducting a minor’s IRA contribution from earned income is negligible since their earned income is low,
- If the money is used to pay for college expenses, taxes are owed on the portion of the distribution that would otherwise be subject to income taxes – which is the majority of the distribution,
- If the money is kept until retirement, the taxes on distributions after 40 or 50 years of compounding will dwarf any tax savings realized at the time the money was earned.
So for all intents and purposes, putting your kid on the payroll, opening and contributing earned income to a Roth IRA, is the prudent and financially savvy way to get your child started on the right financial foot.
As always, all financial decisions should be made with an understanding of your complete financial picture. Talk to your financial advisor to see what actions you should take, given your personal circumstances, to ensure a prosperous future for you and your family.