If you plan to pay for your child’s college education, chances are you know what a 529 plan is. What you may not know is that you can also use a Roth IRA for college savings. There are significant pros and cons of each savings account. So, before you open one or the other, it’s important to understand the differences between using a 529 plan or a Roth IRA for college savings.
Before we dive in and compare we do have a few words of wisdom about using a Roth IRA for college savings.
The bonus of using a Roth to save for college is that if your child does not go to college, you’ve helped him or her get a running start towards retirement savings (if the account is established in the child’s name). As long as a person has earned income, they can open and contribute to a Roth IRA.
If the account’s in your name, you can garner quite a hefty nest egg to spend as you please if the funds end up not being used for the education of the child. But, if you plan to open and fund a Roth IRA in your own name for this purpose, keep this in mind: It is going to cost you a lot more to retire than it will to put your child through college. So, make sure you have your own retirement squared away first.
If you’re set for retirement in other ways, you and your spouse (or even grandparents of the child) could open a Roth IRA intended for funding college expenses. If this account is opened when the child is born, and contribution limits are maxed out every year until the child turns 18 (especially if you’re 50+ and can take advantage of the additional catch-up contributions), the account could amass somewhere around $99,000 - $117,000 for that education from contributions alone. If both parents contribute, that could be $198,000 - $234,000—which can be used on anything you desire since you’re able to withdraw the contributions penalty and tax-free. Additionally—you can also name the child as the beneficiary of the IRA and leave them a considerable financial legacy when you pass away.
It may sound like a Roth IRA is the way to go for college savings, but—not so fast. As we said, there are huge differences in each strategy. You must understand the nuances of each to determine which is the best scenario for you!
The Pros and Cons a Roth IRA and a 529 Plan for College Savings
- Funds available in the Roth don’t affect most financial aid calculations, whereas about 5.65% of a 529 plans value does. However, distributions from a Roth account are considered income on a FAFSA application pertaining to financial aid and definitely affect that bottom line.
- Contributions to a Roth are currently restricted to $5,500 a year (with a catch-up allowance of $1,000 for those 50 and older). A 529 plan allows contributions of up to $15,000 thanks to the gift tax consideration here. Additionally, both parents can contribute separately, bringing that amount up to $30,000 a year. You can also take advantage of the gift tax provision allowing contributions of up to $75,000 ($150,000 for couples making joint contributions) in one year—in essence, making a five calendar-year period contribution in one transaction. This can be beneficial for estate planning, even if parents simply want to front-load all of the funding.
- Contributions on a Roth IRA cannot be deducted on your income tax form, whereas 529 plan contributions can be if your state allows that deduction.
- Roth plans are more flexible and can use a large variety of investments to build tax-deferred wealth in the plan. A 529 account is more limited in assets it uses, which can inhibit healthy growth depending on how well those assets perform.
- Unused funds can remain in a Roth account until the account holder reaches retirement age (59 ½) and can take tax and penalty-free distributions. Excess funds not spent on college in a 529 account are subject to a 10 percent penalty and taxation when removed from the plan.
- Income gained in the Roth IRA through investments is subject to taxation on the federal and state levels when withdrawn before age 59 ½ and if you held the account for less than five years. All withdrawals from a 529 or Coverdell account are tax-free when spent on qualified education expenses.
There are experts on both sides of the fence regarding using a Roth IRA or a 529 plan for college savings. At the end of the day, it is you who must decide which account is best for your intentions. Consult your financial or tax advisor to help make this decision