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Updated on Wednesday, January 8, 2020
529 vs Roth IRA: How they compare
529 plans are offered either by your state or by an individual school. They are accounts created specifically for saving for education expenses. A 529 plan is an investment account, so you contribute money and choose investments; over time, the account grows with annual returns.
Roth IRAs are mainly for retirement savings. You contribute with post-tax dollars, so when it comes time to withdraw your money, you don’t have to pay taxes again. However, some people opt to use Roth IRAs for education savings, too.
But which is best for you? 529 plans and Roth IRAs differ in several key ways.
1. Tax benefits and penalties
According to Lloyd Sacks, a Certified Financial Planner and managing director of the private client group at Sacks & Associates, contributing to a 529 plan has some benefits when it comes to your taxes.
“Some states allow a deduction for contributions made to in-state 529 plans,” he said.
That deduction can help reduce your taxable income, potentially leading to a smaller tax bill.
Roth IRAs don’t offer the same benefit. However, withdrawals from Roth IRAs contributions are free from income taxes.
2. Withdrawal rules for education
If you withdraw earnings from a Roth IRA before your retirement, you typically are subject to early withdrawal penalties. However, there is an exception in some circumstances.
“If [the money is] used for qualified higher education expenses, the 10% early withdrawal penalty on earnings is waived, but you are still responsible for taxes on the earnings in this case,” Sacks said.
529 plan withdrawals can only be used for education expenses, or you will be subject to penalties and taxes. You’ll pay the full income tax on the withdrawal, plus a 10% penalty fee.
3. Investment options
With a Roth IRA, you have several different investment options. You can invest in individual securities, such as stocks, bonds, certificates of deposit, exchange-traded funds, or mutual funds.
529 plans have fewer options. Depending on which state you open your 529 in, you may only have access to a small range of investment options, such as index funds. You aren’t limited to opening a 529 in your home state so it pays to shop around for the best investments options and lowest fees.
4. Contribution limits
Roth IRAs and 529 plans have very different contribution limits. If you want to save aggressively, a 529 plan allows you to sock away more money than a Roth IRA.
For 2020, the annual contribution limits for a Roth IRA are set at $6,000, with a $1,000 catch-up contribution for those over the age of 50. Meanwhile, 529 plan contribution limits are set by individual states.
5. Financial aid
What savings vehicle you choose can impact the financial aid package your child is eligible to receive. The Free Application for Federal Student Aid (FAFSA) looks at your savings differently depending on the type of account you use.
“Retirement accounts, like a Roth IRA, are not considered assets on the FAFSA, and will not impact a student’s ability to receive financial aid for college,” said Sacks.
Because Roth IRA accounts are exempt from the FAFSA, your Roth IRA balance won’t affect what financial aid your child is eligible to receive. A 529 plan balance, on the other hand, can affect your FAFSA.
“A 529 plan will impact a student’s ability to receive financial assistance towards college expenses,” said Sacks.
However, that doesn’t mean that one is better than the other. With a 529 plan, there are tax advantages to making contributions, which can be an effective tradeoff against FAFSA implications.
6. Plan B: What if you don’t use it for college?
When it comes to planning for college, it can be hard to predict where your child will be at the age of 18. If your child decides not to go to college, that can affect your finances.
With a 529 plan, you’re subject to a 10% penalty if you don’t use the money for qualified education expenses for the selected beneficiary, which can eat up a big chunk of your savings. If your child does decide not to go to school, you can switch the beneficiary to another child, another relative, or yourself. You can also use the funds to pay for trade school or even K-12 education.
A Roth IRA doesn’t carry the same penalties. If your child decides against going to school, you can keep the money in your savings for your retirement, penalty-free.
You should consider a Roth IRA for college savings if:
- Your retirement savings are low. If you don’t have substantial savings for retirement yet, a Roth IRA can do double duty; you can save for retirement while simultaneously saving for college. If your child doesn’t go to college, you can use the funds you saved for your retirement.
- If you’re not sure your child will go to college. Because the Roth IRA offers greater flexibility, it’s a better option if you’re not certain your child will go on to a university.
You should consider a 529 plan for college savings if:
- You need to save aggressively. If there are only a few years left until college, or you think your child will opt for a more expensive private school, contributing to a 529 plan with higher contribution limits makes more sense than a Roth IRA.
- You aren’t eligible for a Roth IRA. If you’re ineligible for a Roth because your income is too high, a 529 plan makes sense.
- Your state offers a tax deduction. Some states offer tax benefits if you contribute to a 529 plan, making them a smarter option.
Saving for college
Saving for college can be overwhelming, especially when it comes to deciding on the best savings plan for you. If you’re torn between a Roth IRA and a 529 plan, the Roth IRA offers greater flexibility.
“Unless the clients fall into the high net-worth category or are fairly affluent, I usually recommend saving and investing in a Roth IRA if they are eligible to contribute to one,” said Sacks. “By utilizing the Roth IRA, a client is able to save for college expenses while also funding their own personal retirement in the event they fall short of their savings goals through other means; the funds within a Roth IRA can be used for either purpose.”