Q. I’ve gone over my budget carefully and I’ve made all kinds of cuts. I have an extra $540 to save each month. I already max out my 401(k) and IRA, and I have a good emergency fund. Should I save this for college for my 4-year-old? We have a 529 plan with about $10,000 and we add family gifts, etc. but no regular contributions. I’m 46 and my wife is 48.
A. Congratulations on being so thoughtful about what to do with your extra cash flow. Way too many people squander extra dollars instead of using them to reach important goals.
Let’s first look more closely at your retirement savings.
If a couple – or even one spouse — is maxing out their 401(k) contribution ($18,000 for those under age 50 in 2015) in addition to making a maximum IRA contribution ($5,500 for those under age 50 years of age in 2015), it’s important to review if the IRA contribution is deductible, said Taylor Thomas, a certified financial planner with Round Table Wealth in Westfield.
That could change your decision and affect the budget, he said.
Assuming you and your wife both work and are both covered by employer retirement plans, IRA contributions should be deductible if you couple file a joint tax return and have less than $98,000 of Modified Adjusted Gross Income, Taylor said.
“Modified AGI is basically your gross income adjusted for certain deductions,” he said. “Please note that deduction eligibility changes if one spouse is not covered by a retirement plan at his/her employer.”
So, if your Modified AGI is less than $98,000, then making the IRA contribution in addition to the 401(k) contribution should be an advisable option, Taylor said.
Once the Modified AGI goes over $98,000 the IRA deduction begins to be “phased out,” and it’s fully phased out at $118,000.
“If Modified AGI is over $118,000 the couple would no longer receive a deduction for contributions to an IRA and should consider other options like funding a Roth IRA, which is available up to Modified AGI of $183,000 for a joint-filing couple before it is phased out, or adding to taxable savings,” Taylor said.
You also need to review your emergency fund to make sure you have enough. How much is enough is a different answer for every family.
Taylor said typically, if both spouses are employed with a stable, regular income, an emergency fund that covers three to six months of spending needs should suffice. Additional funds might be required if the family is living on a single income or has commission-based income, which can vary.
Now to that extra money you have.
You didn’t mention if you have any debt, which is an important consideration here.
“Paying down — or off — `bad debts,’ like credit cards, installment loans or any liability which is charging a high rate of interest should be considered before funding a 529 account,” Taylor said. “If the couple is free of these types of debt, I am comfortable with them directing this extra cash to a 529 account for their child.”
But there is another option.
If your Modified AGI is less than $183,000 for 2015, you could contribute up to $5,500 to a Roth IRA, said Jim McCarthy, a certified financial planner with Directional Wealth Management in Rockaway.
He said there are several reasons you may want to use a Roth instead of a 529 plan, specifically for college savings.
“College 529 plans are considered ‘parental’ assets for financial aid purposes when completing the FAFSA (Free Application for Federal Student Aid) and thus will impact how much financial aid your child might receive,” McCarthy said. “Retirement accounts such as 401(k)s, IRAs and Roths are not considered in completing the FAFSA.”
Both 529s and Roths are funded with after-tax dollars, accumulate tax-deferred, and can provide tax-free distributions if certain criteria are met, he said. But distributions from the 529 are tax-free only if used for qualified higher education expenses, which includes tuition, fees, books, supplies, equipment, and the additional expenses of a “special needs” beneficiary. Any other distributions from a 529 are considered non-qualified and are subject to a 10 percent penalty plus ordinary income tax on the earnings portion of the distribution, he said.
“Distributions from a Roth are tax-free only if the owner is over 59 1/2 years old and the distribution occurs at least five years after the initial contribution to the Roth, he said.
Also, in general, 529 plans offer limited investment options, while you can invest a Roth in anything.
“Given that both you and your wife will reach 59 ½ by the time your child enters college, you would be able to use tax-free Roth distributions to help pay for college,” McCarthy said. “Please note that the timing and type of these distributions may cause them to be included in the FAFSA calculation. This strategy has the added benefit of providing `tax-diversification’ in your retirement savings.”
Another idea: Once your child is old enough to generate their own ‘earned’ income (babysitting, yard work, mothers’ helpers, entrepreneurial endeavors, etc.), you can open a Roth in their name and contribute up to 100 percent of their ‘earned’ income, he said. Just be sure to keep good records.
“The child’s Roth is not included in the FAFSA,” McCarthy said. “Your child can then withdraw any contributions — not earnings — from the Roth without penalty or tax for college costs. This is also a great way to teach your child about saving and investing.”
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