529 Savings Plan vs. Roth IRA

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Roth IRA versus 529 for college savings

529s Insights

529 Savings Plan vs. Roth IRA

Aaron Levitt Mar 25, 2020


With student loan debt skyrocketing and education costs rising,many parents are looking to help defer the financial burden on their children. Under that guise, 529 plans have emerged as one of the best ways to save for future higher education needs.

But, they are not the only way. In fact, an account you probably already have and use for another purpose likely has the ability to be tapped into for higher education. And in some circumstances, it may actually be a better choice. We’re talking about the humble Roth IRA.

Click here to learn more about 529 savings plan.


An IRA for College Savings


Under normal circumstances, savers need to wait until they’re 59.5 years of age in order to take advantage of the Roth IRA’s 100% tax-free withdrawal rates. After all, the account was designed to facilitate retirement savings. Pulling money out too early results in earnings being both taxed and penalized.

Since contributions to a Roth account are made with after-tax money, savers can always withdraw their contributions tax-free. For example, if you’ve contributed $75,000 to your Roth IRA and it’s now worth $100,000, you are allowed to withdraw up to $75,000 at any time without paying penalties. Taxes would only be applicable to the $25,000 in gains.

This fact makes the Roth an interesting savings vehicle for a variety of other uses. And, as far as college savings go, the Roth has a few other wins as well.

For one thing, if you are using the Roth savings for college – for you, your spouse, your children or your grandchildren – you can withdraw the earnings penalty-free. You’ll still owe taxes on that money, but you won’t have to pay the additional 10% early withdrawal fee. Secondly, money inside a Roth IRA isn’t counted as an asset for financial aid purposes or needs to be reported on the Free Application for Federal Student Aid (FAFSA). However, once withdrawn, the money counts as income on the FAFSA for the following year.

Meanwhile, Roth withdrawals can be used for additional higher education needs that don’t necessarily meet the definition of required or approved costs: groceries, clothes, car insurance, etc., are all considered parts of going to college these days. The Roth plan allows parents to pay for these essential items that other accounts might not afford.

And we can’t forget that the Roth account offers virtually limitless investment options.

The ability to withdraw money without additional penalties could make the Roth a powerful vehicle for college savings.


Disadvantages Of Using A Roth Vs. A 529 Plan


For starters, the contribution limits on a Roth are much lower. 529s offer no annual contribution limits, and deposits up to $15,000 or $30,000 for married couples filing jointly will qualify for the annual gift tax exclusion. Meanwhile, there are ways to “front-load” a 529 plan with five years’ worth of contributions at once. This contrasts to a Roth IRA, which only allows annual contributions at a current rate of $6,000 per year. More importantly, not all savers can even qualify for a Roth due to income restrictions.

Then we also have to consider current tax deductions. With a Roth plan, there are none. However, a 529 plan may offer state tax deductions for residents of the respective state’s plan. This can be a powerful bonus, in addition to the tax deferral and tax-free withdrawals of the plan.

Check out our state plans section here to learn more about the rules and regulations pertaining to each U.S. state.

Finally, when it comes to getting aid, 529 plans do appear to outperform Roths. Withdrawals from parent- or student-owned 529 accounts are excluded from federal income tax return and are not added into base-year income on the following year’s FAFSA. Income is one of the biggest detriments to getting aid. Meanwhile, only 5.64% of 529 plans assets are used in the EFC formula section of the FAFSA. This could provide more federal aid for a student than with a Roth.


Which Is Better: Roth or 529?


Both accounts offer plenty of advantages and disadvantages when it comes to college. Perhaps the best course of action would be to use both and make contributions to both. Plan on using your 529 account for your student’s college savings and your Roth for your retirement. But also know that there’s some flexibility with the Roth to pay for other items not covered by a 529 plan.

And, if you can only afford to contribute to one of the accounts, the Roth should be your go-to. In the end, note that a Roth can be used for much more than just retirement savings.

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