Should I tap a child’s Roth IRA to pay for tuition?

Dear Liz: My teenage daughter has a modest amount in a Roth IRA that has only a very small gain. I am thinking about using the principal on her private high school tuition so that the account is not considered when she applies for college tuition aid. Is this shortsighted?

Another factor is that I have inherited part of the estate of a relative. Although the transfer isn’t finalized, I probably will get the money during the same year that will be used to determine the financial aid for her first year in college.

Would she be better off if I left the Roth alone and used the inheritance? Or should I reduce the funds in her account?

Answer: Leave that Roth alone!

Retirement funds aren’t included in federal financial aid calculations. And it’s an awful idea to use retirement funds for educational expenses in any case.

Left alone, even a modest sum in a Roth can grow substantially, particularly because it will be 50 years or so before she reaches retirement. In that time, a $5,000 balance could grow to nearly $235,000, assuming she averages 8% annual returns.

Your inheritance will affect your daughter’s financial aid package, but perhaps not by as much as you think. The federal aid formula generally requires you to contribute less than 6% of your “discretionary” assets toward your children’s education.

Are annuities ever a good idea for children?

Dear Liz: I’m a financial planner who liked your answer to the dad who wanted to fund his children’s IRAs but was shocked to see your recommendation (though with caveats) to purchase annuities.

I can’t imagine annuities would be suitable for children under any circumstances. Only under the best possible scenario of assumptions would an investment in an annuity—even a low-cost annuity—beat a reasonably tax-efficient mutual fund over any time period.

As long as money withdrawn from an annuity remains taxable as ordinary income, and as long as ordinary income tax rates are measurably higher than capital gains rates, this will be the case. I fear that brokers will be handing out your article as a tool to sell annuities for kids. To get an endorsement from someone of your reputation has probably helped some of them make this week’s sales goals. Let’s hope not!

Answer: Let’s hope not, indeed. Annuities tend to have high costs and do just one thing efficiently: turn capital gains that would otherwise qualify for low tax rates into ordinary income, which is taxed at a much higher rate.

Most investors would, as you point out, be much better off investing in index funds or other tax-efficient mutual funds.

However, annuities have one advantage that might appeal to this dad: They’re typically not counted in financial aid formulas, according to FinAid.org founder Mark Kantrowitz, because they’re considered retirement accounts. If the children don’t have enough earned income to fund IRAs, annuities would allow him to start saving for their retirements without having to worry about reducing their future aid packages.

This advantage may not outweigh all the disadvantages of annuities. But it’s something the dad should know about as he’s mulling over his options.

Can we afford a private college for our son?

Dear Liz: We are facing a challenge in regard to financing our son’s education. We are being asked to contribute $30,000 a year for a private college education. Is this really a wise move? We have a daughter who will be in college in two years. Help!

Answer: A good education is virtually essential to success in today’s competitive, global economy. That said, there are plenty of ways to get a good education, and bankrupting yourselves on a too expensive college shouldn’t be one of them.

If you can’t manage this bill without sacrificing your own retirement plans or your daughter’s education, then you need to think about some options.

If your son has his heart set on this college, then he should be willing to take on at least part of the cost by incurring student loans. (He should be careful, though, to make sure that his total student loan debt doesn’t exceed the salary he expects to make in his first year out of school.)

Another option, obviously, is for him to attend a less expensive school for at least a couple of years, if not the duration of his education.

The fact that you’re asking this question just months before your son starts college indicates that you haven’t done enough thinking and planning, but it’s not too late.

Head to the bookstore or library and grab a copy of a college financing guide and explore your options. You might also use FinAid.org’s expected family contribution calculator, available at http://www.finaid.org , to estimate how much you’ll have to kick in once your daughter starts school.

Good luck.

Are annuities OK for kids?

Dear Liz: I’m a financial planner who liked your answer to the dad who wanted to fund his children’s IRAs but was shocked to see your recommendation (though with caveats) to purchase annuities.

I can’t imagine annuities would be suitable for children under any circumstances. Only under the best possible scenario of assumptions would an investment in an annuity (even a low-cost annuity) beat a reasonably tax-efficient mutual fund over any time period.

As long as money withdrawn from an annuity remains taxable as ordinary income, and as long as ordinary income tax rates are measurably higher than capital gains rates, this will be the case. I fear that brokers will be handing out your article as a tool to sell annuities for kids. To get an endorsement from someone of your reputation has probably helped some of them make this week’s sales goals. Let’s hope not!

Answer: Let’s hope not, indeed. Annuities tend to have high costs and do just one thing efficiently: turn capital gains that would otherwise qualify for low tax rates into ordinary income, which is taxed at a much higher rate.

Most investors would, as you point out, be much better off investing in index funds or other tax-efficient mutual funds.

However, annuities have one advantage that might appeal to this dad: They’re typically not counted in financial aid formulas, according to FinAid.org founder Mark Kantrowitz, because they’re considered retirement accounts. If the children don’t have enough earned income to fund IRAs, annuities would allow him to start saving for their retirements without having to worry about reducing their future aid packages.

This advantage may not outweigh all the disadvantages of annuities. But it’s something the dad should know about as he’s mulling over his options.

529 as Tax Shelter?

Q: I was confused about a statement you made regarding penalties on withdrawals from 529 college savings plans. You mentioned a 10% penalty on withdrawals that aren’t used for qualified education expenses but didn’t say whether the penalty applies to the entire withdrawal or just the earnings.

If it’s just the earnings, why should I care about the penalty? Even if I don’t use the money for education, I’d still be ahead because the money had a chance to grow tax-deferred.

A: That would be a heck of a loophole, wouldn’t it? But, alas, it doesn’t exist.

It’s true that only the earnings in your 529 are subject to the penalty, not your original contributions. But you’ll also have to pay regular income taxes on any gains that you withdraw.

The combination of taxes and penalties effectively eliminates the 529 as a tax shelter for most folks unless the money is used for education — or unless they’re in a much lower tax bracket when they withdraw the money than they were during the years in which the gains were accrued.