529 Plan vs Roth IRA: Which is Better for College Savings?October 25, 2022
As a parent, you want to do everything you can to help your child succeed. That’s why so many parents stress about the cost of college and how their child will pay for it.
According to the College Savings Foundation’s 2022 Parent Survey, 65% of parents said they were saving for their children’s higher education. However, only 29% of those parents utilized a 529 savings plan.
Why is that number so low? Some people avoid 529 plans because they believe they’re too restrictive. For those savers, another possible option is a Roth IRA. There are pros and cons to each approach, so let’s take a look at both options to see which one might be the best fit for your family.
What Is a 529?
A 529 is a tax-advantaged account that can be used to cover a beneficiary’s eligible education. A state or educational institution sponsors the account, and there are two types of 529s:
- Prepaid tuition plan: With a prepaid tuition plan, the account holder pays for tuition credits at today’s prices. These credits can be used at in-state public colleges, out-of-state public colleges, and some private colleges.
- Education savings plan: An education savings plan functions more like a traditional investment account. The account holder invests money in the account, which grows tax-deferred. The money can be used for eligible college expenses, including tuition, room and board, books, and computers.
529 plans are usually used for qualifying college expenses, but the money in the funds can also be used to pay for a beneficiary’s elementary or secondary education at a private school.
- Tax benefits: With a 529, the money in the account grows tax-deferred, and withdrawals are tax-free as long as they’re used for eligible college expenses. Depending on where you live, you may be eligible for state tax incentives as well. For example, taxpayers in Pennsylvania that contribute to a 529 can deduct up to $16,000 in contributions per beneficiary per year from their state-taxable income. You can find out what benefits your state offers through BlackRock.
- Contribution limits: 529 plans tend to have much higher contribution limits than Roth IRAs. With a 529 plan, you can contribute up to $500,000 (or more) depending on your state’s rules.
- Distributions: Distributions from a parent- or student-owned 529 for qualified education expenses don’t count as income on the Free Application for Federal Student Aid (FAFSA), so the 529 won’t impact your eligibility for federal or institutional aid.
- Limited investment options: With a 529, the plan has a limited menu of investment options to choose from, so you may be more limited in how you invest your contributions.
- Fund use: When you open a 529 plan, you must designate a beneficiary. The money within the fund can only be used for that beneficiary. If the beneficiary decides not to go to college, you can switch beneficiaries, but the restrictions on how the money can be used may be frustrating for some.
- Penalties: Money saved in a 529 plan must be used for the beneficiary’s qualified education expenses. Any other uses will incur a 10% penalty, and you’ll owe income taxes on the withdrawals.
What Is a Roth IRA?
An individual retirement account (IRA) is a way to save and invest for your retirement. But what does an IRA have to do with college? Roth IRAs can actually be valuable accounts to save for college because of how they are structured.
Roth IRAs are a type of IRA that allows you to contribute to the account with after-tax dollars. While there isn’t an upfront tax benefit to a Roth IRA, your account can grow tax-deferred, and any withdrawals you make after the age of 59 ½ are tax-free. Before retirement, you can withdraw your contributions — but not the earnings — tax-free too.
- Withdrawals: Because your contributions are made with after-tax dollars, you can withdraw your contributions from your Roth IRA to pay for a child’s college expenses without paying penalties or income taxes.
- Tax-free distributions: A Roth IRA can serve dual purposes: allow you to pay for some college expenses and save for your retirement. Once you reach 59 ½, you can take money out of the account tax-free to cover your retirement expenses.
- Investment options: You can open a Roth IRA on your own with most brokerage firms. With a Roth IRA, you have more investment options, including individual stocks, mutual funds, exchange-traded funds (ETFs), and bonds.
- Contribution limits: With a Roth IRA, the maximum you can contribute is $6,000 per year ($7,000 if you’re 50 years of age or older). Even if you max out the account every year, it may not be enough to cover your child’s total cost of attendance.
- Income restrictions: Not everyone is eligible for a Roth IRA. You can only contribute to a Roth IRA if your income is under $144,000 per year ($214,000 for couples that are married and file joint returns).
- Financial aid: Withdrawals from a Roth IRA count as income for financial aid. If you make substantial withdrawals to pay for college, it could hurt your child’s eligibility for future financial aid.
Roth IRA vs 529: Which Is Better for You?
Roth IRAs and 529 plans can both be valuable tools for saving for college. Each has advantages and drawbacks, so it’s important to research your options before opening an account.
Using a Roth IRA to pay for college is a non-traditional strategy, but it can make sense if you aren’t sure your child will attend college. If your child decides against college, you can withdraw the contributions tax-free for any purpose. And if you withdraw the money after reaching 59 ½, the contributions and earnings are tax-free.
A 529 plan makes more sense if your child is committed to attending college, particularly if they may attend a more expensive private school or need to earn a master’s degree too. A 529 plan has higher contribution limits and additional tax benefits, making it a good option for college-focused students.
Roth IRAs and 529 plans can pay for your child’s college expenses and help them avoid taking on too much student loan debt. Whichever account type you choose, start contributing as early as possible to take advantage of compound interest. You can use the U.S. Securities and Exchange Commission’s compound interest calculator to see how your contributions can grow over time.