Many people assume that a Section 529 plan is the ideal college savings tool. But the Roth IRA can also help parents save for college expenses. This article reviews the strengths of each. For example, Sec. 529 plans allow participants to make substantial nondeductible contributions. Owners of Roth IRAs can withdraw contributions anytime, tax- and penalty-free, for any purpose.
Sec. 529 vs. Roth IRA plans
Choosing a college savings tool
Many people assume that a Section 529 plan is the ideal college savings tool. After all, it’s called a “college savings plan.” But other vehicles can help parents save for college expenses — for example, the Roth IRA.
Which one should you choose? It depends on several factors, including how much you intend to contribute and how you’ll use the earnings.
A 529 plan allows participants to make substantial nondeductible contributions — up to $400,000 or more, depending on the plan. The funds grow tax-free and there’s no tax on withdrawals provided they’re used for “qualified higher education expenses,” such as tuition, fees, books, computers, and room and board. If you use the funds for other purposes, you’ll be subject to taxes and a 10% penalty on the earnings portion. Some 529 plans are also eligible for state tax breaks.
Roth IRA contributions also are nondeductible and grow tax-free. And you can withdraw those contributions anytime, tax- and penalty-free, for any purpose. Qualified distributions of earnings — generally, after age 59½ and more than five years after your first contribution — are also tax- and penalty-free.
Advantages and drawbacks
The main advantages of 529 plans are generous contribution limits and the ability to accept contributions from relatives or friends. Roth IRAs, on the other hand, are subject to annual contribution limits of $6,000 ($7,000 if you’re 50 or older). So, even if you and your spouse each set up Roth IRAs when your child is born, the most you’ll be able to contribute over 18 years is $216,000. Another drawback is that you can’t contribute to a Roth IRA if your income exceeds certain limits. (But it may be possible to avoid this obstacle, by using a “backdoor Roth IRA” strategy.)
Funds in a 529 plan that aren’t used for qualified education expenses will eventually trigger taxes and penalties when they’re withdrawn. However, with a Roth IRA you can use contributions, as well as qualified distributions of earnings, for any purpose without triggering taxes or penalties. This includes items that wouldn’t be qualified expenses under a 529 plan, such as a car or off-campus housing expenses that exceed the college’s room and board allowance. Plus, if you don’t need all of your Roth IRA funds for college expenses, you can leave them in the account indefinitely.
Before selecting a plan, consider your overall financial, retirement and estate planning goals. Your financial advisor can help.