Kids College Savings - 529 vs Coverdale vs Roth IRA

[Jim Goebel]

Hi everyone, We've been thinking through the best way to save for kids college. We have two kids and have been maxing out our state's 529 plan. Quinn is a 3 year old boy and has about $18,000 in a 529 account already, and Sarah is 6 months and has $3,500 roughly. I just became aware of what's called a Coverdale account, which lets you bundle or partner separate accounts with an existing IRA account. This sounds appealing as our bread and butter and success has come from RE, but of course to buy the best upside deals, one has to have a minimum level of capital - so this creates challenges with growing something rapidly in a Coverdale, because the annual contribution limit(s) are $2k/child. As I understand it, that's total, so you don't get to contribute that on a per parent basis.

In a 529, we are kind of forced to invest in standard offerings (much like a 401k) through our state's program, so we do not have the option of taking advantage of the returns being achieved in our RE, which have been substantial and far better than the stock market.

Although I do have desire to diversify especially for the kids, I'm also wanting to rapidly grow an asset base for them that will create income, going back into the account.  The sooner we do this, the sooner we can justify not socking money away which takes money out of our cash flow and household.

My Self Directed IRA owns a roughly $150,000 asset free and clear and produces about $1,100 / mo in free and clear income, which is great. There's also about $25,000 in cash in that account to work with. The issue as I understand it, is that my Traditional Self Directed IRA, and only a ROTH IRA has the tax free benefits of a withdrawal for qualified educational expenses. I was just informed over the phone by our self directed IRA custodian Strata Trust that there is a way to transfer balances (including RE assets) from a traditional into a ROTH IRA, which sounds great.

The other avenue that I was exploring was going down the Coverdale, and partnering with the Self Directed IRA funds, to continue doing real estate. This was suggested by a representative at a custodian called Equity Trust. She seems knowledgable and it got me thinking about ways to use RE to more rapidly increase funds in these accounts for the kids.

Now, if I'm understanding correctly, especially given that we already have nice base within the self directed IRA - it seems that if there's the same tax advantages (no penalty upon withdrawal for college, mainly) - at this point I'm seeing pretty much NO advantage to the 529 or Coverdale accounts, beyond, perhaps, if we wanted to go beyond our contribution limits for one - and if we didn't want to use the Self Directed IRA account for those college savings purposes.

If this is the case, I am leaning towards advocating in our family to wean the 529 contributions significantly (but not entirely) and keep aggressively working to grow the Self Directed IRA balance, and acquire additional income producing assets. And, transferring over to a ROTH Self Directed IRA, vs. the traditional that's in place now. I'm wondering what I'm missing in terms of any downsides/disadvantages. Advice welcome, thanks in advance!!!

[Scott Jensen]

@Jim Goebel 

Hi Jim, I’ll give it a shot. So, lets start at the beginning…

When you earn income, the wonderful folks at the IRS tax it. They take it right out of your paycheck. In April of the following you file income taxes… you fill out the forms which tell you how much tax was actually due. Then this number is compared to the amount withheld from your paycheck. If you withheld more than what was due, you get a refund. If you withheld less than what was due, you owe in.

When you make a contribution to a Traditional IRA or a Traditional 401(k) the money you contributed does not count as your taxable income for that year. So, if you made $100,000 and contributed $10,000 to one of these accounts, on your tax return it is like you only earned $90,000. So then $90,000 is all that you are taxed on.

The catch, however, is that when you finally take the $10,000 out of the account (even in retirement) it gets added to your taxable income. In addition, any gains that are in the account also get taxed the same way when you withdraw them from the account. So, if the account grows from 10,000 to 20,000 and you withdraw that whole amount in a single year it all gets added to your taxable income.

Traditional IRA : Tax Break today in exchange for taxes due in the future

With a Roth IRA, it works in the opposite way. Lets say you earn that same $100,000 and want to put $10,000 into a Roth IRA. You do not get a deduction in the current year, you're still paying income taxes on the full $100,000.

When you reach age 59 ½ and take money out of the Roth IRA, however, it does not get added to your taxable income. Likewise, if the $10,000 you put into the account grows to $20,000 you can take it all out and pay no tax on the amount you originally put in or the growth.

Roth IRA: Tax Due today in exchange for NO taxes in the future

The interesting feature of the Roth IRA that makes is really beneficial for a lot of people is that you are able to take out the "Basis" at any time, at any age, for any reason, without any taxes or penalties.

The amount you can take out at any time is the sum of all the contributions you made to the account PLUS any amount you converted from a Traditional IRA to a Roth at least 5 years ago.

When you transfer money (or assets) from a Traditional IRA to a Roth IRA it is called a Roth Conversion. The amount you convert is added to your taxable income in the year you convert it…but after 5 years is considered Roth Basis and is can be withdrawn tax and penalty free after 5 years.

So, what people do (especially common in the FI community) is convert a certain amount of money from their IRA to Roth every year so it will be available for distributions. For example, if you convert $12,000 to Roth each year starting in 2019, then in 2024 you could start withdrawing the $12,000 each year without taking the early withdrawal penalty. This is a Roth Conversion Ladder.

Honestly, it is way easier for me to explain it over the phone. If you want clarification, send me a DM and I can talk you through it over the phone.