If you have the option of saving for college in a 529 plan or a Roth IRA, which should you choose?
Factors to be considered
These factors are important: parental retirement plans and funding, parental income now and projected for the future, contribution limits, ownership and control of contributions, investment options and costs, tax consequences for both parents and dependent children, financial aid impacts, and flexibility or lack thereof of what can be done with unused balances.
And then you can add the uncertainties that come with children in terms of interest in college and alternatives to college, choices of schools and majors made and possibly changed later, and assumptions or pressure from parents as to what their child “ought” to do.
A simple way to think about the choice
Let’s start with three generalities and then consider them in more detail:
- If you are uncertain as to whether your retirement savings are going to be sufficient, or if you are unsure that money set aside will be necessarily used for college, choose the Roth IRA. Money in Roths can be used for either purpose and many others.
- If you are convinced that you want to set aside money specifically and only for education, that you are certain that your retirement savings are on track, that you have a satisfactory plan for paying down debt, and that you can reliably predict now what your child will wish to do when reaching college age, seriously consider a 529 plan.
- If you have sufficient financial resources to fund both after meeting retirement objectives and planning for future healthcare expenses, consider yourself very fortunate and fund both.
Major differences between 529 and Roth IRA plans
The variety and number of investment options are likely to be far greater in Roth IRAs than they are in 529s. The longer the investment time period the more important this becomes.
Qualified withdrawals from Roths can be used for any purpose, 529 withdrawals must be used for qualified educational expenses. The IRS determines in both cases the meaning of “qualified”.
Money can be withdrawn from Roths at any time without incurring a withdrawal penalty when the funds are used for qualified educational expenses. Up to $10,000 per year can be withdrawn from 529 plans for qualified educational expenses, including expenses for K-12.
Allowable individual contributions for Roths are $6,000 per year or $7,000 if the holder is aged 50 or over, but there may be income limits that limit contributions or disallow them entirely. Even if a spouse has no earned income, a spousal Roth IRA can be opened doubling the allowable total contribution to $12,000 or $14,000 for those aged 50 and over.
Allowable contributions for 529s are $15,000 per year for individuals or $30,000 per year for couples. And by using an accelerated gifting provision, five years’ worth of annual contributions can be made in one year provided no further contributions are made in the next four years.
Financial aid impact – the impact of 529 plans depends on who owns the plan. If the plan is owned by a dependent student or a dependent student’s parent, the impact on eligibility for financial aid is minimal.
If the plan is owned by anyone else such as a grandparent or non-custodial parent, distributions are counted as untaxed income to the beneficiary, and that could have a significant negative effect on eligibility. There are some ways to deal with this, and they should be discussed with a knowledgeable expert on student financial aid.
Only one Roth can be opened per individual; there is no limit on the number of 529 plans per individual. However, there is a maximum aggregated amount that can be contributed, and that amount varies by state ($200K to $400K).
If there is money remaining in a 529 plan the owner of the plan can change the plan’s beneficiary to another family member. The family can also withdraw funds left over but they will be counted and taxed as income and a 10% penalty will be assessed on the earnings portion of the withdrawal. You cannot change ownership for a Roth plan.
Money in 529 plans can not be used to pay off student loans as they are not considered a “qualified higher education expense”. Money in Roths can be used for any purpose.
Some states offer a state tax deduction (not a tax credit) for 529 plan contributions. Note this applies to the state in which you are a resident, not the state from which you get the plan. There are no state tax deductions for Roths. Before you opt for a 529 plan make sure you know how your home state treats both state tax deductions and withdrawals for K-12 expenses for state tax purposes.
Thinking and planning for the future
In choosing between a 529 plan and a Roth IRA you are being asked to predict the future: your future retirement needs and your future need for helping meet a child’s future education costs. Ask yourself which need is more likely to be predictable with accuracy, and which is more easily modifiable as the respective times approach.
Consider that college may be very different in the future than what we experienced as parents in terms of cost, time required, and locations. And keep in mind that educational expenditures are likely bounded by 4-6 year time frames, whereas retirement is, hopefully, going to have a 20-40 year time frame.