Many young parents immediately start socking money away in a 529 college savings plan when their baby is born. And that's smart, because 529s offer a lot of benefits when saving for college. Not only are contributions tax deductible in many states, but the money grows tax-free, and all withdrawals are tax-free if they're used to pay tuition or other qualifying educational expenses.
But what if junior decides not to go to college? Or what if 10 years from now the traditional four-year college degree is upended by online learning and college costs a fraction of what it does today? (We can dream, can't we?) If you have most of your money saved in a 529, you'll pay a 10 percent penalty each time you withdraw cash for noneducational purposes.
That's why Robert Schmansky, a financial adviser at Clear Financial Advisors in Livonia, Michigan, is such a strong proponent of Roth IRAs. He says that most parents are only familiar with the retirement benefits of Roth IRAs, namely that you can withdraw money tax-free once you're older than 59½.
"But you can also use Roth IRAs to help pay for college," says Schmansky. "You're allowed to deduct your contributions for any reason whatsoever without a penalty, just not the growth."
What that means is that parents can take out any of the money they've put into a Roth IRA without incurring the 10 percent early-withdrawal penalty. They just can't touch the interest.
The result is flexibility. If a child needs help paying for tuition or covering student loans, mom and dad can pull some money from their Roth IRA. But if the kid doesn't need the money, mom and dad aren't stuck with an education-only savings account, and they can keep more for retirement.
Roth IRAs do have some limitations: You can't contribute more than $5,500 a year, or $6,500 a year if you're 50 or older. These amounts "phase out" or get reduced once you start making over $118,000 as a single person or $186,000 for married couples filing jointly. (More details here.)