Back to School with Grandma's Tax-Free Tip
April 4, 2023
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Most of us can’t help but remember the first day of school and all that comes with it, from new kicks (shoes), to new digs (clothes), to a fresh haircut.

 

As kids, we may have looked forward to that once-a-year splurge when mom and dad would take us back-to-school shopping. Whether it was new school supplies or a new backpack, we were just happy to show off the new stuff. From grade school through high school, parents and grandparents often spent anywhere from $100 to $400 on us every year. These days, add-on electronics used by classrooms or that designer-brand backpack that grandma bought for Kaila who started 7th grade this year can make the range go up substantially. Then comes college, where the average cost of tuition at four-year institutions may cost around $30,000 plus. As you take all these costs in, you hear grandma say to Kaila, “don’t worry, it was tax-free!” You think to yourself “Wait, what?”

OK, let’s talk about college savings vehicles with tax-free and other options. Whether it be for kids or grandkids, college is a common expense on retiree’s minds when creating a retirement plan. When it comes to planning for college, there are 529 plans, Coverdell education savings accounts (Coverdell ESAs), paying cash, and many other types of savings vehicles. Our focus will briefly be on 529 plans and more so on Roth IRAs. Yes, we said Roth IRAs.

 

529 Plans

  • Tax-free withdrawals” are available for the beneficiary’s qualified educational expenses during the year.

  • People can make annual contributions up to $17,000 without having to file a gift tax return (can do a one-time lump sum for five years of contributions; consult with a tax professional for additional information).

  • Contributions can be made by anyone (parents, uncles, grandparents, etc.).

  • Assets can be transferred from one beneficiary child to another if all the funds are not used.

  • Beginning in 2024, unused funds may be transferred to a 529 plan beneficiary’s Roth IRA, subject to limitations.

 

Roth IRAs

  • These IRAs provide the power of tax deferral.

  • Qualified distributions are tax-free and can be used for any expense, not just qualified educational expenses.

    • There is a five-year time test and an event test (attainment of age 59½, death, disability, or first-time home buyer with lifetime limit).
       
  • Contributions have annual limits and income thresholds.

  • Roth IRAs can be funded by processing conversions from IRA assets with no annual limits or income thresholds.

  • There are opportunities to invest in different retirement vehicles for potential earnings.

  • Roth IRAs can be used for legacy planning.

 

Making Sense of Grandma’s Comment

When saving for school expenses, consider using a combination of all available vehicles. Understanding the limitations of each savings vehicle can help with planning. A 529 plan may be great; however, what if your child or grandchild is the next hall of fame quarterback and receives a sports scholarship? He may then need money for noneducational expenses, making the distributions nonqualified, and the earnings may then be taxable. A Coverdell education savings account has contribution limits, which hardly cover the cost of books at most universities. A Roth IRA, on the other hand, is a different subject, and I’ll explain why.

Simply put, Roth IRA assets can be used for anything and are tax-free if they are qualified distributions. Grandma can take money from her Roth IRA and buy Kaila the expensive backpack without having to worry about increasing her taxable income, which could affect taxes on her Social Security benefits. Or, she can buy Kaila a used car for college, using Roth IRA assets and avoid taxes. Now, grandma’s “tax-free” comment is starting to make sense.

Also, once all the kids and grandkids are finished with college, she can use the remaining Roth assets toward discretional expenses in her retirement. With 529 plans, if there are remaining assets, they may be transferred to other beneficiaries with limited amounts transferred to the beneficiary’s Roth IRA starting in 2024, subject to limitations. However, there could be taxes on the remaining amounts if withdrawn for nonqualified expenses.

As school expenses continue to rise and you find yourself planning for them, take in grandma’s tax-free tip and remember that 529 plans may not cover all the expenses. Having other savings vehicles such as a Roth IRA may be a helpful solution.

 


 

This material is educational and intended for an audience with financial services knowledge.


 

For more information on retirement-planning strategies, please contact the Retirement Strategies Group at (800) 722-2333, or email us at RSG@PacificLife.com

 


 

 

 


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