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.

 

To read all of the Late Stage Col­lege Plan­ning blog series click here.