Roth IRA vs. 529 Plan: Which Is Best for College Savings?

College is expensive, and the cost continues to rise. It’s enough to make any parent nervous about whether they’ll be able to provide their children with the education they deserve.

So how can you get a head start? Just like retirement, one of the best ways to make things easier on yourself is to use a savings account that offers tax breaks. Those tax breaks reduce the cost of saving, allowing your money go even farther.

And when it comes to saving for college, there are two accounts that offer more tax breaks than any other: the 529 plan and the Roth IRA. Both are fantastic options, and in this article we’ll break down each one so that you know whether to choose a 529 plan or Roth IRA for your college savings.

Here’s what we’ll cover:

  1. The pros and cons of 529 plans
  2. The pros and cons of using a Roth IRA for college savings
  3. How to decide which one is right for you

Pros of 529 Plans

A 529 plan is a dedicated college savings account that offers special tax advantages when used for college expenses.

There are two types of 529 plans: savings plans and prepaid tuition plans. For this article we’ll focus on savings plans since those are the most common.

Here are the pros of using a 529 plan for college savings.

Tax Advantages

A 529 plan works a lot like a Roth IRA — it’s just designed for college instead of retirement:

  • There is no deduction for contributions (though we’ll discuss some exceptions below).
  • Money grows tax-free while inside the account.
  • Money can be withdrawn tax-free for qualified higher education expenses.

Other than a Coverdell ESA, which has other limitations, no other account offers this many tax benefits for college savings.

Potential State Income Tax Deduction

In some cases you can get a state income tax deduction if you contribute to your home state’s 529 plan. You can find a complete overview of each state’s allowed deduction here.

Keep in mind that you’re allowed to use a 529 plan from any state, not just your own. So whether or not your state offers an income tax deduction, you can choose to use another state’s plan if you think it’s a better option.

High Contribution Limits

There are no income limits on 529 plan contributions, so they’re available to everyone. You’re also allowed to contribute quite a lot. Most plans simply have a total contribution limit that’s usually in the $200,000 to $400,000 range.

There’s technically no annual contribution limit, though in most cases it’s a good idea to stay within the limits of the annual gift tax exclusion. For 2016, that means that each parent can contribute up to $14,000 for each child without gift tax implications. If you’re married, that means up to $28,000 per year for each child.

There’s even a rule that allows you to contribute up to five times that amount in a single year if you’d like. In other words, if you want to contribute a lot of money towards college, a 529 plan is a good way to do it.

Flexibility to Change Beneficiaries

If your child doesn’t end up needing all of the money you saved, you can use it for someone else.

You’re allowed to change the beneficiary of a 529 plan to any member of the original beneficiary’s family. Typically that would mean a brother or sister, or even you or your spouse.

So if one child doesn’t end up needing the money, there are easy ways to make sure it doesn’t go to waste.

Flexibility With Scholarships

Typically, there are taxes and penalties if you withdraw money from a 529 plan and don’t use it for college expenses (more on this just below).

But there are certain exceptions, and scholarships are one of them. If your child qualifies for a scholarship, you can withdraw up to the amount of that scholarship penalty-free.

You’ll still have to pay taxes on the earnings (any investment gains from your original contributions), but that just means you’ll have gotten tax-deferred growth in the meantime. And in any case it’s nice to know that you won’t be penalized if your child is able to use his or her talents to pay for a college education.

Cons of 529 Plans

While 529 plans are incredibly helpful in the right situations, you shouldn’t necessarily start contributing as soon as you have children. Here are three big reasons to consider alternatives:

Penalties and Taxes If Not Used for College

Though there are some exceptions for things like scholarships, for the most part money within a 529 plan will be taxed and penalized if it’s withdrawn for anything other than qualified higher education expenses. And if you received a state income tax deduction for your contributions, you may have to pay that back as well.

This is worth considering since there are a lot potential reasons that you might want to use this money for other goals:

  • Your child may go to a lower cost school than you anticipated.
  • Your child may not want to go to school at all.
  • The trend could reverse and college could become less expensive in the future.
  • You might need money for something else in the meantime.

It’s worth noting that only the earnings in the account will be taxed and penalized. The amount you’ve contributed won’t be subject to either. But every withdrawal is counted as part contribution and part earnings, so in most cases you won’t be able to completely avoid the penalties.

Limited Investment Options

Like 401(k)s, 529 plans all offer a relatively limited lineup of investments. Depending on the plan you’re considering, that could mean that you don’t have a lot of good options.

For example, some plans are filled with expensive investments. And while cost isn’t the only factor to consider, it is the single best predictor of future investment returns and high-cost investments will be a significant obstacle to success.

The good news is that you’re allowed to choose any 529 plan offered by any state. You aren’t limited to your state’s plan and there are plenty of states that offer a strong lineup of high-quality, low-cost investments. You can see some of my favorite 529 plans here, and you can compare 529 plan costs here.

So in many cases the limited set of investments doesn’t have to be a big deal, but it could be an issue in the following situations:

  1. You get an income tax deduction if you use your state’s plan, but your state’s plan is high cost.
  2. You have a specific investment strategy you want to implement and you can’t do it within a 529 plan.

Limited to Higher Education

Unlike a Coverdell ESA, you can’t use money withing a 529 plan for private school or tutoring before college. Your withdrawals are only tax-free if they’re used for higher education expenses.

So again, there’s just a little bit less flexibility with a 529 plan than with other accounts.

Pros of Roth IRAs for College Savings

While the Roth IRA is technically a retirement account, it has some characteristics that can also make it an effective way to save for college. In some situations, it may even be preferable to using a 529 plan.

Here are some of the benefits of using a Roth IRA for college savings.

Special Withdrawal Rule for Higher Education

Roth IRA withdrawals are 100% tax-free once you reach age 59.5, but the earnings are typically taxed and penalized if they’re withdrawn before then. Which means that in most cases you’ll want to avoid early withdrawals.

But there are some special rules that allow you to get around those penalties, especially if you’re withdrawing the money for college expenses:

  1. You can withdraw up to the amount you’ve contributed without taxes or penalties at any time and for any reason. For example, if you’ve contributed $50,000 to your Roth IRA and it’s grown to $75,000, you can withdraw up to $50,000 any time you want without consequence.
  2. You can withdraw the earnings penalty-free (but not tax-free) if the money is used for college expenses for you, your spouse, your children, or your grandchildren.

While this isn’t quite the same tax benefit as that offered by 529 plans, it’s still better than most other accounts.

Tax Deferral in the Meantime

Like a 529 plan, your money also grows tax-free while inside of a Roth IRA. This allows your money to grow faster than it would inside of most other accounts.

Flexibility

The biggest reason to choose a Roth IRA over a 529 plan is the flexibility you have to use the money for various purposes.

For example, it’s generally more important to save for retirement than to save for college, simply because there are many ways to pay for a college education but you have only yourself to rely on for retirement.

With a Roth IRA, you can save money now and decide later what you want to use it for. If your retirement is on track through other accounts, you can direct the money to your child’s education. If not, you can keep the money in the Roth IRA for retirement.

And even beyond that, Roth IRAs are extremely flexible accounts with many potential uses, so contributing to a Roth IRA can open up more opportunities than contributing to a 529 plan.

Not Counted as Asset for Financial Aid

Many people worry about contributing to a 529 plan because of the impact on financial aid. That worry is largely overblown, mostly because only about 5% of the money inside of a 529 plan is actually counted for financial aid purposes, and because having money is much better than needing it.

Still, a Roth IRA isn’t counted as an asset for financial aid purposes at all, and the last time I checked 0% is less than 5%. So in some situations, having your college savings in a Roth IRA may help you qualify for financial aid.

More Investment Options

Unlike 529 plans, you can invest in just about anything you want within a Roth IRA. That means that you can both minimize your investment costs and implement any investment strategy you choose.

Cons of Roth IRAs for College Savings

Roth IRAs can be a great way to save for college, both because of the tax benefits and the flexibility to use the money for whatever opportunities you and your children want to pursue. But there are some downsides as well, and here are some of the biggest.

Fewer Tax Benefits

A Roth IRA offers fewer tax benefits than a 529 plan IF the money is used for higher education.

  • 529 plans allow for tax-free withdrawals of earnings, while Roth IRAs do not (at least, not until you’re age 59-1/2).
  • Some states offer income tax deductions for contributions to a 529 plan. Roth IRAs never get this benefit.

If the money you’re saving does end up being used for college expenses, a 529 plan will likely save you more money.

Potential Financial Aid Trap

While the money inside of a Roth IRA is not counted toward financial aid, withdrawals from a Roth IRA are counted. And those withdrawals can have a big impact.

Most people worry that saving money will hurt their financial aid eligibility, but the reality is that your income will have a much bigger impact. According to SavingforCollege.com, only 2.6% to 5.6% of your savings is counted on the FAFSA while 22% to 47% of your income is counted.

And for financial aid purposes, 100% of withdrawals from a Roth IRA and other retirement accounts count as income, even if the money isn’t taxed as income.

For example, remember above when I said that you can withdraw up to the amount you’ve contributed to a Roth IRA at any time without tax or penalty? That’s still true, but it WILL be counted as income on your FAFSA application, which will likely hurt your child’s chances for financial aid.

One way around this is to simply wait until your child’s last year of college to withdraw money from a Roth IRA, but of course you may need the money before then. And even if you don’t, that strategy could hurt a younger child’s financial aid eligibility.

Just know that if you are applying for financial aid, you need to be very careful about withdrawing money from a Roth IRA.

Sacrificing Valuable Retirement Space

You risk sacrificing valuable retirement space when you use a Roth IRA for college savings.

If your retirement is 100% covered by other accounts, then this isn’t a big deal. But if not, be careful not to count this money as being available for both retirement and college. It can only be used for one, and when push comes to shove retirement should usually get the nod.

Smaller Contribution Limits

Unlike 529 plans, Roth IRAs have some pretty significant contribution limits.

First, each person can only contribute up to $5,500 per year ($6,500 if you’re 50+). Second, there are income limits that may prevent you from contributing at all.

If you’d like to save a lot of money for college expenses, the Roth IRA likely isn’t going to cut it.

How to Choose Between a 529 Plan and Roth IRA

So, how do you choose the right account for your specific needs? There are a lot of variables to consider, but here are some general rules of thumb.

If you’re not on track for retirement yet, go with the Roth IRA. Retirement is a more important goal and this way the money will be available for either purpose.

If you’re not sure that you want to use the money for college, go with the Roth IRA. It’s a more flexible account that allows you to use the money for a variety of reasons without penalty.

If you’re 100% sure that you want to save this money specifically for higher education, go with the 529 plan. The tax benefits and high contribution limits make it the best option for money that’s dedicated to that purpose.

Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.

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