Have you been thinking of saving for your child’s college education? You’ve probably heard of a 529 plan and a Roth IRA. They are both tax-smart ways to set aside money for college but there are some differences. We discuss below the pros and cons of a 529 college savings plan vs a Roth IRA, so that you can make the best decision for you and your family.
What is a 529 college savings plan?
A 529 plan is a tax-advantaged investment account that you can use to save for your child’s college. There are no income requirements to open a 529 account but you must be a US resident and your child must have a social security number.
529 plans are usually sponsored by individual states. If you live in DC, there’s a DC 529 plan. Virginia has their own 529 plan. But does that mean if you open, for example, a California 529 plan, your child must attend college in California? It does not. If you live in New York, does that mean you should contribute to the NY 529 plan? Not necessarily.
What are the two types of 529 plans?
The two types of 529 plans include saving plans and prepaid tuition plans.
- Savings plans: this plan allows you to contribute regularly as your earnings grow. Your money is invested, usually in a mutual fund, and the growth will depend on that investment’s performance. This is the most popular option but you do take on more investment risk.
- Prepaid tuition plans: this is when you lock in current tuition rates at in-state public institutions. However, if your child decides to go to a private or out-of-state institution then you may only receive a small return on your original investment.
What are the advantages of a 529 college savings plan?
- Through a 529 plan, you can invest your savings or your child’s savings for college. That means you can invest it in either stocks or bonds and it can potentially grow, versus just letting it sit in a checking or savings account.
- Your 529 plan will grow tax-deferred and distributions are tax-free, as long as they are used for education expenses. Education expenses may include college tuition and fees, books and supplies, and room and board. For example, if you put $10,000 this year in a 529 plan and it grows, for example, to $20,000 over the next 18 years, you don’t have to pay taxes on the $10,000 of growth that you made inside of that 529 plan, as long as you use the funds for qualified educational expenses.
- State tax benefits: 529 plans are the only college savings plans that provide state tax benefits. In some states, you can deduct your 529 contributions from your state income tax return. This means the contributions are tax-deductible in your state. So in other words, you can get a tax benefit from your state when you deduct your contributions, and then you can get a tax benefit from the federal government when you withdraw the growth tax-free.
- Low maintenance: You can open a 529 plan online or through a financial planner. You can set up an automatic investment and link it to your bank account so you can set it and forget it.
- High contribution limits: 529 plans have no annual contribution limits and have high aggregate limits. The maximum aggregate limits vary by state and they range from $235,000 (Georgia) to $529,000 (California).
- Favorable financial aid treatment: Certain assets and retirement accounts make it hard to receive financial aid. A 529 plan is reported as a parent’s asset and therefore has a minimal effect on financial aid eligibility. Only 5.64% of the value of the 529 accounts is counted against the child’s financial aid eligibility. Distributions from 529 accounts are not reported as income on the FAFSA.
- Flexibility to invest in any 529 plan: You can invest in almost any state’s 529 plan and you don’t have to go to school or live in that particular state.
- Transferable to another eligible family member: If one of your children decides to not go to college, then you can transfer the 529 account beneficiary to another child or even yourself. There are no federal tax implications when you transfer a 529 to another qualified beneficiary and there are typically no state or local taxes either. It is important to know that you can only roll a 529 over to another 529 with no income tax once every 12 months.
Let’s look at how much tax savings you can generate by saving through a 529 college savings plan. In the graph below (from the Journal Financial Planning), we can see that saving through a 529 savings plan enabled the parents to earn more than $29,000 more in investment earnings, compared to a bank account. This assumes that the parents saved $64,000 and they generated a certain investment return in their 529 savings plan. In addition, the parents generated more than $10,000 in tax savings through the plan, for a total benefit of more than $40,000.
Source: Journal of Financial Planning
The 529 college savings plan also offers some flexibility.
- You can use the money not just for tuition, but for other education expenses like room & board, a computer, books, and school supplies.
- Can be used for graduate school (in case your child gets a full college scholarship).
- You can change the beneficiary. So if your daughter got her scholarship and doesn’t need the money, you can change the beneficiary of the account to your son. If they are both super smart and get scholarships, you can even think about using it for your own graduate or Ph.D. program or saving it for future grandchildren.
- 529 rollovers to a Roth IRA will now be allowed from January 1, 2024. The rollover is subject to rules.
What are the disadvantages of a 529 college savings plan?
While a 529 savings plan has many great benefits, it also has a few disadvantages to be aware of.
- Distributions must be used for education expenses, otherwise you will be subject to federal and state taxes and a 10% early withdrawal fee: The main disadvantage of saving through a 529 college savings plan is the money has to be used for education. So if your only child decides not to go to college, then when you have to take out the money that you saved in a 529 college savings plan, you have to pay federal and state taxes on the earnings in addition to a 10% penalty for withdrawing the money for expenses other than education. So if for some reason, you wake up one day and you say, “You know what? That $50,000 that I saved in my 529 plan I’m just going to take it out and buy a Tesla. I feel like doing that.” You’re going to have to pay that 10% withdrawal penalty plus taxes because you’re not using it for education.
However, there are a few exceptions to the penalty. If your child gets a full college scholarship or attends a US Military Academy, for example, the 10% penalty for withdrawing the funds is waived.
Under the SECURE Act 2.0, from January 1, 2024, 529 rollovers to a Roth IRA will be allowed. By doing so, many people can avoid the 10% penalty if they want to use their 529 funds for something other than educational expenses. However, there are some additional rules. The 529 account must have been opened for at least 15 years, you are still subject to the Roth IRA annual contribution limits, and you can only roll over $35,000 throughout your lifetime.
- Limited investment options: 529 plans don’t allow for self-directed investments. This means that you don’t get too many investment options, and some types of investments might be missing from the 529 menu. This may be disappointing to savvy investors who want flexibility and control over their portfolios.
- Fees: The more that you have to pay in fees then the less you can save for college. Some 529 plans have fees that are charged annually and some charge a percentage of the total account balance. It’s important to research all of the 529 plans and find a low-cost 529 plan that meets your needs.
- Ownership rules: The account owners have control over the funds in the 529 account. The owner can change the beneficiary, make withdrawals, or liquidate the plan. While most 529 accounts are owned by parents or grandparents, it is important to understand who controls the account.
Advantages and disadvantages of a 529 college savings plan
|Advantages of a 529 plan||Disadvantages of a 529 plan|
|Tax-deferred growth||The funds must be used for education|
|Tax-free withdrawals, if used for education expenses||Limited investment options|
|Tax-deductible contributions (for some plans)||Fees|
|Favorable financial aid treatment||Subject to early withdrawal fee of 10% if not used for education.|
|Can transfer to another qualifying family member||Account owners have control over the funds.|
|Easy to open and low maintenance|
|High contribution limit|
What is a Roth IRA?
A Roth IRA is a retirement account that allows you to save after-tax dollars and potentially grow them tax-free. You can withdraw your contributions at any time without any penalties. After you reach age 59 ½ and have had your account open for at least 5 years, then you can also make tax-free withdrawals.
What are the advantages of a Roth IRA?
There are several advantages to a Roth IRA such as:
- Tax-free withdrawals in retirement: You contribute to a Roth IRA with after-tax dollars so this means that your contributions have already been taxed. When you withdraw funds in retirement, you won’t owe taxes on the contributions or investment earnings.
- No required minimum distributions (RMDs): This means that you can leave your money in your Roth IRA for as long as you’d like and let it continue to grow tax-free.
- Flexibility with contributions: You can withdraw your contributions (not earnings) at any time without any penalties. This allows for a little flexibility if you need to access that money for some reason.
- No age restrictions: Anyone can contribute to a Roth IRA, regardless of age, as long as they have earned income.
- Estate planning benefits: Roth IRAs can be a valuable estate planning tool. You can leave tax-free assets to your beneficiaries.
What are the disadvantages of a Roth IRA?
A Roth IRA can be a great retirement savings tool but there are some disadvantages to be aware of:
- No immediate tax benefit: Contributions are made with after-tax dollars which means that you won’t get a tax deduction for contributing to a Roth IRA.
- Contribution limits: There are annual contributions limits and some people may want to invest more for retirement. A workaround for this is a backdoor Roth.
- Income limits: If you make too much money then you may not be able to contribute to a Roth IRA.
- Potential penalties: If you withdraw your earnings from your Roth IRA before age 59 ½ then you will have to pay a penalty. There are some exceptions to this rule.
Advantages and disadvantages of a Roth IRA
|Advantages of a Roth IRA||Disadvantages of a Roth IRA|
|Contributions and earnings grow tax free.||The annual contribution is low. The annual contribution amount for 2023 is $6,500 (or $7,500 if you are aged 50 and older).|
|Contributions can be withdrawn at any time without penalties. However, earnings cannot be withdrawn at any time.||There are income limits.|
|Once you reach age 59½, you can withdraw that money tax-free and penalty-free.||There’s no state income tax deduction for Roth contributions|
|No required minimum distributions (RMDs).||There are penalties if you withdraw your earnings from your Roth IRA before age 59 ½.|
|There are no age requirements. As long as you have earned income then you can contribute to a Roth IRA.|
Roth IRA vs 529 Plan: Key Differences
Roth IRA and 529 Savings Plans are both great ways to save for college. Here are some key differences between the two:
|529 plan||Roth IRA|
|State Income Tax Benefit||Over 30 states, including DC and Virginia, allow state income tax deductions or tax credit on 529 plan contributions.||No states offer tax deductions or credits for Roth IRAs.|
|Annual contribution limits 2023||No contribution limits.|
Aggregate limits range from $235,000 to $553,098, depending on the state.
|$6,500 per year (or $7,500 for those aged 50 or older).|
|Earned income cap on contributions||No earned income cap on contributions||There is an earned income cap on contributions.|
|5 year gift tax averaging||$85,000 limit ($170,000 for couples) applies for 529 plans.||Not subject to the 5 year gift tax averaging rule|
|Aggregate contribution limits||There are limits and these vary by state. The limit is usually between $235,000 and $550,000||No aggregate contribution limit|
|Third party contributions||Allowed||Not allowed|
|Investment options||Limited investment options||Offer a broad range of investment options including stocks, bonds, mutual fund and EFTs.|
|Qualified Distributions||Tax-free if they are used to pay for qualified higher education expenses or K-12 tuition.||Tax-free return on contributions|
|Financial aid impact||Reported as an asset on FAFSA. Parent-owned 529 plan assets count against financial aid and can reduce aid by up to 5.64%.||Not reported as assets on the FAFSA.|
Frequently asked questions about Roth IRAs and 529 College Savings Plans:
– Is a 529 plan the same as a Roth IRA?
No, a 529 plan and a Roth IRA are not the same things. A 529 plan is a tax-advantaged savings plan designed specifically for education expenses. Contributions are made with after-tax dollars and the withdrawals are tax-free when used for qualified education expenses. A Roth IRA is a retirement savings plan. Contributions are made with after-tax dollars and the money can be withdrawn tax-free in retirement.
Both plans offer tax benefits but they do serve different purposes and are subject to different rules. It’s important to carefully consider each option before choosing which approach is best for saving for college for your family.
– Can you get a tax deduction on 529 plan or Roth IRA contributions?
Contributions to 529 plans and Roth IRAs are not deductible on your federal tax return. However, some states offer tax deductibles when you contribute to their 529 plan.
– How do I open a 529 plan?
Opening a 529 plan is a straightforward process. The first step is to go to the SavingforCollege.com website. You can then look at all of the state plans available to you. Some states offer state income tax deductions for contributions to their plan. Also, make sure that you compare the fees and investment options of different plans before making a decision.
Once you’ve chosen your 529 plan then you can complete the application. Once your application is processed and your account is opened, you can start making contributions to your 529 plan. You may have to make an initial minimum contribution. Each state’s plan has different rules and requirements so be sure to consult with your financial advisor if you have any questions.
– Where should you open a 529 plan?
The answer to this question depends on a few different factors. If you live in a state that offers tax-deductible benefits, and the investment options of that college 529 plan are really good, then you might consider contributing to your state’s 529 plan. For example, if you live in DC, Virginia, Maryland, or Colorado, your 529 contributions are tax-deductible.
In terms of fund fees, the 529 Maryland investment funds range from 0.06% to 0.55% in fees. The 529 VA (Virginia) funds range from 0.09% to 0.72%. The 529 DC funds range from 0.15% to 0.74%. The lower the fees, you get to keep more of your money.
If you live in a state that offers no tax-deductible benefits (such as California), or if your state offers tax incentives but the fund options are not good, you can shop around among other 529 plans. This is really where a financial planner can be of assistance.
– What happens to 529 plan money if my child gets a scholarship?
If your child gets a scholarship then you still have several options for what to do with the 529 plan money.
- Use the funds for qualified expenses that are not covered by the scholarship: This includes expenses like room, board, and transportation.
- Use the funds for non-qualified expenses: You can withdraw the money for any purpose but you will owe income tax and a 10% penalty on the earnings of the withdrawal.
- Change the beneficiary: You can change the beneficiary on the 529 plan to another family member to use for qualified education expenses.
- Keep the money in the 529 plan: You can keep the money in the 529 plan and use it for future education expenses.
- Rollover your unused 529 funds to a Roth IRA: Beginning in 2024, you can also convert excess funds from a 529 to your child’sRoth IRA.
– Can I start a Roth IRA for my child?
A Roth IRA isn’t typically considered a savings vehicle for kids, but if your children have earned income during that year then you can start a kids Roth IRA. The 2023 contribution limit for a Roth IRA is $6,500, or the amount of the child’s earned income, whichever is less.
– Can you use a Roth IRA for college?
Yes, you may use money from a Roth IRA for college expenses but there are some restrictions. You can withdraw your contributions tax-free and penalty-free as long as you have had your Roth IRA open for 5 years. However, if you withdraw the earnings from a Roth IRA for education expenses then you won’t incur the 10% early withdrawal penalty, but you will still be subject to federal income tax on those earnings.
– Is there a limit on how many times you can withdraw money from your Roth IRA for college tuition?
There is no limit on how many times you can withdraw money from your Roth IRA to pay for college tuition. However, you may still owe tax on the earnings that you withdraw if you have had your Roth IRA for less than 5 years and you are younger than 59 ½.
– Can you roll over unused 529 funds to a Roth IRA?
Yes. Beginning in 2024, you can convert excess funds from a 529 to your child’s Roth IRA. This change came about because some families were concerned about saving too much in a 529 plan and not being able to use those funds for anything but education expenses.
– How much can you roll over from a 529 to a Roth IRA?
You will be able to roll over up to $35,000 to your child’s Roth IRA throughout your lifetime. Under the SECURE Act 2.0, these new rules will take effect on January 1, 2024. The 529 account must have been open for more than 15 years and the rollovers are subject to the Roth IRA annual contribution limits. If you are thinking of rolling over some funds from your 529 to a Roth IRA, it’s best to consult a financial advisor first.
– What are some alternatives to a 529 or Roth IRA?
While 529 plans and Roth IRAs are great college savings options, they do have some disadvantages. It may be worth exploring alternatives to see if they fit you and your family better. Some alternatives to 529 plans include:
– Brokerage Accounts
– Savings Accounts
– UGMA Accounts
– UTMA Accounts
– Coverdell Education Savings Accounts
– What are some things to consider before I choose a 529 plan or a Roth IRA?
Below are some questions that you may want to ask yourself before choosing a 529 plan or a Roth IRA.
- How much do you want to contribute? A Roth IRA has a maximum annual contribution for 2023 of $6,500. Only you can contribute to your Roth IRA. A 529 plan has much higher limits and also allows friends and family to make contributions.
- Does your state have tax advantages? Some states offer tax advantages for contributing to their 529 plan. If your state offers tax advantages, then it may be a good choice for you and your family.
- How much do you make? Roth IRAs have income limits. If you earn above that limit then you cannot contribute to a Roth IRA. 529 plans do not have income limits.
- Who is the beneficiary? If you know that the beneficiary will have educational expenses then a 529 plan may be a great option. However, if you aren’t sure if the beneficiary will have educational expenses then a Roth IRA may be better.
529 vs Roth IRA, which is better?
Some families, including a few of our clients, hesitate to contribute to a 529 plan. They’re worried that maybe their child won’t go to college, and they’ll end up paying taxes and a 10% withdrawal penalty on the 529 plan. Some of them might have a spouse that is a UK citizen and college in Europe might be cheaper than college in the US. In this case, there is an advanced alternative that some financial advisors might have you consider. This alternative is to contribute to a Roth IRA for your child’s education. If you do that, you can take out your contributions, not earnings, but your contributions, without any tax implications or penalties.
Here are some considerations on 529 vs Roth IRA. If you’re eligible for a Roth and you have limited funds, Roth has a very attractive feature for the same reason that I just mentioned. You can take out your contributions at any point in time and you can use it for college. Alternatively, if you change your mind, or don’t need the money for college, you can designate it for your retirement.
The main thing you must think about is that there are no ready-made portfolios like that in 529. You must know how to invest those Roth IRA contributions if you’re earmarking them for a child’s college. The other major consideration is if you are using a retirement fund, like a Roth IRA, to pay for your child’s education, will you have enough for yourself to retire on? You can’t add more to a Roth IRA than the annual max ($6,500 in 2023) regardless of what you intend to use the money for. So if you don’t have enough other funds that are earmarked for retirement, you might not want to consider this option.
If you can potentially do both 529 and Roth IRA, why not do both? You can contribute to a Roth IRA, and get the benefits from that. Then contribute to a 529 and get the benefits from that too. The worst-case scenario with your 529 savings is you can’t use it for your child’s college education for some reason and you have to pay taxes on the earnings. As mentioned above, there are exceptions to the 10% penalty. If an exception applies, taking money out of the 529 is not unlike taking money out of any other tax-deferred account, like a 401(k). You defer the taxes until you withdraw, then you pay them. No harm done.
That’s it! Those are the main considerations when deciding whether to invest in a 529 plan to fund your child’s education. I do have a word of caution: if you’re contributing to a 529 plan, there’s an option to choose target-date portfolios based on your son’s or your daughter’s age. For example, if your child is going to college by 2038, then there is a 2038 portfolio that you can choose as your investment option for the 529 contributions. Sounds easy, right?
I caution you to be careful, because in some cases, not all, the investments in these funds might be too aggressive based on your circumstances. If your child is only three to four years away from college, some target-date 529 portfolios still have that specific target-date portfolio invested in 40% of stocks. Generally, if you’re going to need the money in three to four years, 40% of stocks might be too much money in a very volatile investment. Ask your financial advisor for their recommendations on 529 investment options.
Need help with deciding if you should choose a 529 college savings plan or a Roth IRA?
Whichever plan you choose to save for your child’s college education, the most important decision you can make is to start saving as soon as possible. A fiduciary financial advisor can help you decide whether setting up a 529 college savings plan or a Roth IRA is right for you and your family. They can also run the numbers, so you know how much you need to contribute each month, so your daughter or son can go to the college of her or his choice. Schedule a FREE 30-minute discovery call with one of our financial planners, to help you plan for your child’s dream college today!
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.