Personal Finance

If 529 plans get taxed, here's another tax-free option

A tax shocker: Death of the 529?
A tax shocker: Death of the 529?

President Barack Obama wants to flunk a key provision of the 529 college savings plan.

While it's unlikely to pass through a Republican-controlled Congress, the White House's proposal should be of keen interest to millions of families who may want to come up with alternative ways to pay for college.

The popularity of 529 plansboth college savings and prepaid tuitionhas grown sharply in the past decade. There are more than 12 million accounts in circulation with an estimated $240 billion in total assets at the end of last year, according to the research firm Strategic Insight.

About 7 million families have 529 plans, and most parents likely find the plan attractive for this reason: The after-tax money you put into a 529 plan can be withdrawn tax-free to pay for tuition, room and board, and other qualified education expenses. Under Obama's new proposal, it's this critical benefit that would change. For new contributions, money could no longer be withdrawn tax-free.

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While many families, and financial advisors who have encouraged them to participate in 529 plans, may be shocked by the White House proposal, there is another tax-free option to save and pay for college and it may offer families more flexibility: a Roth IRA.

Ideally, the money that you put away in a Roth IRA should be saved for retirement. Yet many middle-income families may not be aware that after-tax contributions made to a Roth IRA can be withdrawn tax-free at any time to pay for collegeor anything else for that matter, if needed.

Earnings in a Roth IRA can also be withdrawn for college expenses without paying penalties; however, you will have to pay taxes on the earnings. Generally, if you withdraw earnings from a Roth IRA before you are 59 ½ years old that money will be subject to income taxes and a 10 percent penalty. But withdrawals for qualified higher education expenses—for you, your spouse, your children or grandchildren—are an exception, and you do not have to pay the penalty.

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One downside: You can't contribute as much to a Roth IRA as you can to a 529 plan.

The maximum amount that can be contributed to a 529 plan on behalf of each designated beneficiary varies among states, but the IRS generally allows contributions up to "the amount necessary to provide for the qualified education expenses of the beneficiary."

When limits are established, they're usually applied on a lifetime versus an annual basis. (For instance, a plan may limit total contributions to $200,000.) For 2015, you can contribute up to $5,500 to a Roth IRA, or up to $6,500 if you are 50 or older, though you do have until April 15 to contribute to a Roth IRA for the 2014 tax year.

There are also income limits to be fully eligible to contribute to a Roth IRA. This year married couples must have adjusted gross incomes of less than $183,000 ($181,000 for 2014). If you're single, the income threshold is $116,000 ($114,000 for 2014.) But families whose household income is too high to contribute to a Roth IRA could convert a traditional IRA into a Roth IRA and withdraw the Roth money tax-free for college expenses, as long as they follow IRS guidelines.

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