Any parent looking to provide his children the best education will often think of ways to set some money aside to help pay college expenses. While there are many ways to save for college, these two popular savings vehicles come in handy, 529 plan and Roth IRA. Both offer more tax benefits. Here we drill down to the specifics of each so that you know which account is more suitable for college savings.
This is a type of dedicated saving account that offers unique tax benefits when used for college expenses. There are two types of 529 plans, prepaid tuition plans and savings plans. Saving plans are the most common ones, and we will be talking more about them in this piece.
Pros of using a 529 for college savings
Here are some of the tax benefits you get when you use a 529 for college savings:
- Money grows tax-free while inside the account.
- No deduction for contributions but there are penalties and taxes if you withdraw money from a 529 plan and use it for non-college expenses
- You can withdraw money tax-free for qualified education expenses, such as college tuition and textbooks.
High contribution limits
Unlike most plans that set contribution limits, 529 plans have no annual contribution limits. They are available to everyone and give you the freedom to contribute a lot. While they don’t enforce a contribution limit, it is a good idea to stay within the limits of the annual gift tax exclusions. For 2016, each parent can contribute up to $14,000 for each child without gift tax implications. If you are married, that means up to $28,000 per year for each child.
There is even a rule that permits you to contribute up to five times that amount in a single year. Basically, a 529 plan is a good option when looking to contribute more.
Potential state income tax deductions
Some states allow income tax deductions if you contribute to your home state‘s 529 plan. You can learn more here about each state‘s allowed deduction.
You are free to use a 529 plan from any state, not just your own. This means you have the freedom to use another state‘s plan if you find it more appealing.
Flexibility with scholarships
Withdrawing money from a 529 account and using it for non-qualified expenses attracts penalties and taxes, but there are exceptions, and scholarship is one of them. In case your child qualifies for a scholarship, you can withdraw up to the amount of that scholarship penalty-free.
Flexibility to change beneficiaries
Your money won’t go to waste if your child doesn’t use it. A 529 plan allows you to change the beneficiary to any member of the original beneficiary’s family. For example, you can use the money to educate your spouse or other kids.
Cons of 529 plans
Taxes and penalties if money not used for education
If you decide to use money in the 529 account for other expenses besides qualified education expenses, be ready to be taxed and penalized. Unless it is an exception like scholarship, you will be penalized and taxed. If you received state income tax deductions contributions, you might have to pay as well.
It is good to note that only your earning in the account will be penalized and taxed. The amount you have contributed won’t be subject to either. But every withdrawal is counted as a part contribution and part earnings, so in most cases, it will not be possible to dodge penalties.
Limited investment options
529 plans offer limited investment options, just like 401(k)s. While some states offer a strong lineup of high-quality, low-cost investments (you have the freedom to pick any 529 plan offered by any state), these plans still limit your investment options, especially when it comes to these situations:
- You have a particular investment strategy you want to implement, and you can’t do it within a 529 plan.
- You get an income tax deduction if you use your state’s plan, but your state’s plan is high cost.
Here are some of the prime 529 plans we recommend when it comes to investment options.
Roth IRA is another saving vehicle you can use to fund your children’s college education. While it is technically a retirement account, it is also an excellent account for college savings.
Advantages of using a Roth IRA for college savings
Tax deferral in the meantime
Your money grows tax-free inside a Roth IRA just like in a 529 plan. This is a great thing as it allows your money to grow faster.
Not counted as assets for financial aid
Roth IRA plans are not counted as an asset for financial aid. 529 plans are counted as assets for financial aid. In fact, around 5% of the money inside of a 529 plan is counted for financial aid purposes. This means having your college savings in a Roth IRA may help your child qualify for financial aid.
Special withdrawal rule for higher education
All Roth IRA withdrawals are tax-free once you reach age 59.5. Withdrawing earlier attracts penalties and taxes. However, it is possible to avoid penalties if you withdrawal earlier, especially when withdrawing money for college expenses. Here are two special rules:
- You can withdraw your earnings penalty-free but not tax-free if the money is used for college expenses for you, your children, your spouse, or your grandchildren.
- You can withdraw up to the amount you have contributed without penalties or taxes at any time and for any reason. For example, if you have contributed $75,000 to your Roth IRA and it’s grown to $100,000, you can withdraw up to $75,000 any time you want without consequence.
You can use money in your Roth IRA account in many ways. For example, you can use it to fund the education of your children or keep it for your retirement. Besides, Roth IRAs are flexible with many potential uses.
More investment options
With a Roth IRA, you can invest in just anything you want. This gives you the freedom to minimize your investment costs and implement any suitable investment strategy.
Cons of Roth IRAs
Fewer tax benefits
Compared to a 529 plan, a Roth IRA offers fewer benefits if the money is used for college expenses.
529 plans allow for tax-free withdrawals of earnings, while Roth IRAs allow tax-free withdrawals when you reach age 59.5.
Some states allow income tax deductions for contributions to a 529 plan. Roth IRAs never get this benefit.
Small contributions limits
Roth IRAs have very small contributions limits. Each person can only contribute up to $5,500 per year and $6,500 if you are 50+. Additionally, there are income limits that hinder many from contributing at all. So, if looking to contribute more, Roth IRAs are not the best option.
Potential financial aid trap
As aforementioned, one benefit of a Roth IRA account is the eligibility to qualify for financial aid. However, it is good to note withdrawals from a Roth IRA are counted toward financial aid. This means withdrawing money while your child is in college will hurt his or her eligibility for financial assistance.
You can increase your child’s eligibility for financial aid by wait until the last year of college to withdraw the money. While this is an option, it is possible as you will need money before then.
So, if you decide to settle for a Roth IRA account, be very careful about withdrawals.
Sacrificing valuable retirement space
Using your Roth IRA account for college saving puts your retirement savings at stake. This is because you can only use your account for only one option. It is either for retirement or college saving. So, if other accounts do not fully cover your retirement, you may want to take your time before sacrificing the valuable retirement space.
Selecting between a Roth IRA and a 529 plan
Which is the right option for you? Both are great accounts but to help you make a better decision, consider the following:
- Are you certain you are saving for college? If yes, go for a 529 plan because of the high contribution limits and tax benefits.
- Not certain what you want to use the money for? Choose a Roth IRA account as it gives you the freedom to use your money in multiple ways without penalty.
- Not on track for retirement? Again choose a Roth IRA as the money in the account is still available for retirement income.
Is a 529 better than a savings account?
There is no saving vehicle without cons. A 529 plan has its own cons; for example, they will count your money against your child’s financial aid. But if looking for a plan that offers more tax benefits and control, then choose a 529 plan.
Is Roth IRA an excellent way to save for college?
Yes, it is a good account. With it, you can save for both retirement income and college expenses. You can only save for college expenses with 529 plans.
Can a 529 be transferred to a Roth IRA?
It is not possible. The Internal Revenue Code prohibits that, and if you roll over a 529 college savings plan into a Roth IRA, be to pay a 10% penalty and ordinary income taxes on the earnings portion of the distribution.
Can you lose money on a 529 plan?
No. if your child does not use the money, other qualified beneficiaries will use the money. For example, your grandchildren.
Why a 529 is a bad idea?
A 529 plan is a bad idea when your child fails to join college because you can not use the money for other purposes. A 529 plan is solely for college savings. So, if confident your child will not reach college, don’t choose it.