I breezed through the discussion, but because I just posted a tax credit post, I’ll offer my 2 cents, sorry if it is repetitive. You get a little extra gain from the 529 if it is tax deductible from income in your state. Otherwise it is a lot like comparing a Roth versus standard IRA, which is paying tax now versus later. I think the main issue is the tax rate now versus in the future when the IRA funds are withdrawn. MOST people will be in lower tax bracket when they retire, which tends to favor IRA. However, if you are drawing extra amounts from IRA to pay for college, that might push income to a higher tax bracket. I think a 529 is a lot like Roth, but we were not eligible for Roth. Although I am enjoying the benefits of 529, as a policy for the country overall I do not like them because they favor the rich. The more excess money out there for college leads eventually to price inflation and country-club colleges rather than broad availability for everybody.
The other factor is if you are in the income territory for need-based financial aid, IRA money is hidden, 529 money is counted as parental asset.
Rereading your original post, if you are getting need-based financial aid, there is no way that contributing to a 529 helps the appearance of the amount of aid needed, because IRA money is not known about. It all becomes strange because FAFSA is calculated more than a year away from when college money is needed. Ignoring the financial need considerations and state income deduction, 529 versus IRA is exactly like Roth versus IRA assuming the 529 is all spent on college expenses.
I want to expand on a point I made earlier. A couple posts claimed that 529 vs IRA is like Roth vs IRA. If you take out the money freshman year (actually first year and half of college), that is not true. I agree it is true as far as taxes are concerned. However, for financial aid it is not true. When you use a deductible IRA, that income gets added back in the year of the contribution. Then if you withdraw the money from the IRA freshman year, it would be income again. The same money would be counted twice as income for financial aid. This is why I think the OP’s calculations favor the 529 - he correctly understood this point. When you use a 529, ROTH IRA or don’t take the money out of a regular IRA till Jan 1 of sophomore year (because of the prior prior rules), that income is only counted once. Since income is the biggest factor for financial aid, I think this is an important point.
In fact, given only two years of growth for child #1, I think it would be better to leave the money in the bank than do a regular IRA and withdraw the money freshman year. You are talking about two years of tax-free growth (should be very little since that money should be invested conservatively for a goal two years out) vs counting the money as income in more than one year of college.
^ Yes, you get a federal tax savings. But if you sell the IRA two years later, it gets added to taxes that year. You are talking about a break on taxes one year and larger taxes two years later.
You could argue, with the recent tax cuts for 2018 and going forward, that assuming the OPs income doesn’t change, he will be in a lower tax bracket in 2 years, so that favors the trad’l IRA.
With a state tax deduction, I personally would just do the 529.
It has taken me some time to get back to it, but I did research the FAFSA treatment of Roth IRAs. I have come to the conclusion that the bottom line is the same as that for traditional IRAs. As described in my original post, with a traditional IRA you save taxes up front, but then pay them later (which is a wash); but since the distribution is considered income, it reduces FAFSA aid by 47%. With a Roth, you don’t avoid taxes up front, but you don’t pay them later (also a wash); but my reading of the FAFSA instructions is that distributions from a Roth IRA are also considered “untaxed income” and therefore reduce need-based aid eligibility by 47%. In each scenario I assume the distribution is taken prior to Jan 1 of sophomore year.
The wording of the FAFSA instructions invites confusion, however. Line 94e instructs you to add to parental income “Untaxed portions of IRA distributions…” 1) It appears that “IRA” encompasses both traditional IRAs and Roth IRAs, so the instructions apply. 2) In the case of distributions from Roth IRAs, those attributable to contributions have already been taxed and those attributable to earnings are not subject to tax (assuming various conditions are met).
However, the instructions specifically instruct the filer to subtract the amount on line 15b of his/her 1040 form from the amount on line 15a of his/her 1040 form. Line 15a is the amount of the total distribution from the (Roth) IRA and line 15b is any taxable amount from that distribution (eg, anything other than a “qualified distribution”). So while any qualified distribution is not included in AGI (and therefore not subject to tax), FAFSA includes it as “untaxed income”.
PrivateID - you wrote “When you use a 529, ROTH IRA or don’t take the money out of a regular IRA till Jan 1 of sophomore year (because of the prior prior rules), that income is only counted once.” I’m especially interested in your thoughts, given that I reach a different conclusion. Have I missed something?
If your kiddo is in college these years…these Tax years will be used…and FAFSA filed on these dates…examples!
Freshman 2019-2020 . FAFSA filed October 2018. Tax year used 2017.
Sophomore 2020-2021. FAFSA filed October 2019. Tax year used 2018.
Junior 2021-2022. FAFSA filed October 2020. Tax year used 2019.
Senior 2022-2023. FAFSA filed October 2021. Tax year used 2020.
So…just make that withdrawal any time in 2021…which would be Spring of your kid’s sophomore year in college. Assuming she graduates in four years, the 2021 income will NEVER be used on her FAFSA forms. Or Profile…
They use prior prior year tax returns now…and can be filed by October 1 of the year for the following academic year.
It’s only a wash if you’re in the exact same tax situation when you contribute the money to the IRA as you are years later when you retire and take the money out… same tax laws and regulations, same income, etc. There’s no way that’s going to be the case. When you contribute to a traditional IRA, you’re betting that your tax situation will be more advantageous to you in retirement than it is during your earning years. When you contribute to a Roth IRA, you’re betting that your tax situation will be more advantageous to you in your earning years than it is during your retirement.