A 529 college savings plan vs. a Roth IRA. Let’s discuss the pros and cons of each option

Going to college is an exciting adventure, but an expensive one. That is why it is best to start putting aside money for college as early as possible. However, many accounts are available for saving and investment purposes, so you need to research each one in detail. In this article, we will explore the pros and cons of a 529 college savings plan vs. a Roth IRA. Keep reading to learn more about these two investment accounts and how they can help to cover higher education expenses. 

The 529 College Savings Plan

The 529 plan is a savings account that allows you to save for future college expenses. It also offers tax and financial aid benefits. At first, you could only use the funds in a 529 account to pay for higher education expenses. However, the 2017 Tax Cuts and Jobs Act allows for up to $10,000 to be spent on K-12 tuition for each beneficiary every year. 

Almost every state has at least one 529 plan. Also, there is a 529 plan that is operated by a group of private colleges and universities

There are two main types of 529 plans:

  • Prepaid Tuition Plans: These allow you to pay in advance for the beneficiary’s tuition costs at designated schools. 
  • Savings Plans: These are tax-advantaged savings accounts that allow you to invest for future college expenses. 

For this article, we will focus on 529 savings plans. All of these plans are established at the state level. The best news? You do not have to be a resident of a particular state to enroll in its plan. For example, if you live in Florida, you can enroll in a 529 plan in Texas.  

A 529 plan is a good idea – even if the original beneficiary does not enroll in college. The funds in a 529 plan can be allocated to other close family members including yourself via a simple change of beneficiary. 

Furthermore, since the passage of the 2019 SECURE Act, you can use the unused 529 funds to pay off $10,000 of college debts each for the beneficiary and the beneficiary’s siblings.

Pros and Cons of a 529 Plan

Let’s consider some of the pros and cons of a 529 college savings plan:

Pros

  • Contributions to a state-based 529 plan may result in lowered income taxes.
  • Contributions and earnings grow tax-free.
  • There are no income or age limits for a 529 college savings plan.
  • You can make large contributions (up to $75,000) at once to front-load a plan and avoid a gift tax.
  • The 529 plans follow the easy, set-it-forget-it investment model. 
  • There are taxes on withdrawals that are used for qualified education expenses. 
  • You are free to switch beneficiaries, and you can use the proceeds to pay off college loans. 

Cons

  • You must use the funds in a 529 plan for the intended purposes or pay the penalty. 
  • Investment options are limited. 
  • You need to check plans to assess good performance and low fees.
  • Plans are limited to one beneficiary at a time (families with multiple children will need multiple 529 plans). 

More About the Advantages of 529 College Savings Plans

Let’s discuss the advantages of a 529 college savings plan

 

Contributions made to 529 college savings plans are not deductible on your federal income taxes. But if you live in one of the over 30 states that offer income tax advantages for their 529 plans, then you could get a full or partial tax deduction/tax credit. 

Your funds also grow tax-free in a 529 account. Additionally, you will not be taxed when you withdraw money from the plan as long as you use it to pay for qualified education expenses. 

We also like that there are no income or age limits for 529 plans. The annual contribution limits are set by each state. Furthermore, to avoid the federal gift tax, you will need to contribute no more than $15,000 per year, per beneficiary. 

There’s one exception. If you have funds, you can front-load your 529 plan by contributing five years of the gift-tax maximum at once (or $75,000 per beneficiary). This will help you to avoid the gift tax and enjoy rapid growth in your investment.

Finally, a 529 plan is not a complicated investment vehicle. It’s based on the set-it-and-forget-it model. This means that you open an account, contribute regularly, and watch your balance grow now and in the future. 

More About the Disadvantages of 529 College Savings Plans 

With a 529 plan, you face tight restrictions about the use of funds from the plan. The money must be used for its intended purpose, or you will need to pay penalties. These penalties are only assessed on the earnings within the plan. You would pay income tax plus a 10% penalty to take the money back into the account. 

There are several ways to claim an exemption from this 10% penalty, but you’ll still need to pay the income taxes. If the beneficiary decides that he or she is not going to college (or drops out of college), you can make yourself the beneficiary. You would then use the funds to further your education. 

The 529 plans also have limited investments. The offerings vary across states, with some states’ 529 plans performing much better than others. If you’re a savvy investor, then you’ll not like the options you’re given. Make sure that you also compare the fees for each 529 plan. 

What is a Roth IRA?

A Roth IRA (or a Roth individual retirement account) allows you to save for retirement. You can also make qualified withdrawals on a tax-free basis once certain conditions are met. The Roth IRA was established by the Taxpayer Relief Act of 1997 and is named after William Roth, a former Delaware Senator. 

Roth IRAs are similar to traditional IRAs, and the main difference between both is how they are taxed. A Roth IRA is funded with after-tax dollars, so the contributions are not tax-deductible. Therefore, once you start withdrawing the funds, the money is tax-free. 

On the other hand, a traditional IRA is funded with pretax dollars, and the contributions are tax-deductible. Therefore, when you start withdrawing money from these accounts during retirement, you will need to pay income tax on the withdrawals. 

Furthermore, you can’t contribute to a Roth IRA if you make too much money. For 2021, the limit for persons filing as single is $140,000, and the limit for persons filing jointly is $208,000. 

Also, the amount you can contribute will change periodically. In 2021, the contribution limit is $6,000 per annum. However, if you are 50 years or older, you can contribute up to $7,000 each year.

Can You Use a Roth IRA to Save for College?

 

Can you use a Roth IRA to save for college? Let’s discuss!

While a Roth IRA is often used to save for retirement, you can also use it to save for college. Young investors can take advantage of a Roth IRA because when they pay taxes now, they will likely be in a low-income tax bracket.

You can contribute to a Roth IRA at any age as long as you have earned income (or taxable income) and if you don’t make too much money. Unlike traditional IRAs, there are no required minimum distributions (RMDs) with Roth IRAs. So that means you can keep the money in your account if you don’t need it. 

Did you know that teenagers can also contribute to a Roth IRA? They can! Anyone under age 18 will have to open a custodial Roth IRA. to make contributions from their income. And that makes a Roth IRA perfect to save for college as well. 

Pros and Cons of a Roth IRA

The pros and cons of a Roth IRA include:

Pros 

  • Contributions and earnings grow tax-free.
  • You can withdraw your contributions (but not your earnings) at any time without paying income tax or any penalties.
  • Once you get to age 59½, you can withdraw all the funds tax-free and penalty-free to help with your children’s and grandchildren’s expenses. 
  • The rest of the money can remain in your Roth IRA account for future use.  

Cons

  • The annual maximum contribution is relatively low (compared to what you can contribute to a 529 plan). 
  • Your contributions are not tax-deductible. 
  • Roth IRA withdrawals are seen as income for financial aid purposes. These withdrawals can reduce how much financial aid you can get for college. 
  • Donating your Roth IRA funds to loved ones reduces your retirement funds. 

More About the Advantages of a Roth IRA

A Roth IRA can help you save for both retirement and college. Furthermore, the fact that there are no age restrictions on contributing to a Roth IRA makes it attractive for young people to save for their future.

Since your contributions to a Roth IRA are not tax-deductible, your contributions and earnings grow tax-free. And since the account is funded with post-tax dollars, you can withdraw your contributions at any time and for any reason, tax-free. 

Many families use their Roth IRA funds to pay for a part of their children’s college expenses. If you have children later in life or you’re saving for your grandchildren, then a Roth IRA is most suitable. 

Once you get to age 59½ (and it’s been at least five years since you first contributed to a Roth IRA), then all of your withdrawals (earnings and contributions) are tax-free and penalty-free. So 100% of your withdrawals can go to college expenses. 

If you are not 59½ as yet, you will pay income taxes if you withdraw your earnings. However, you would not pay an early withdrawal penalty as long as the funds are used to pay for college expenses. 

Furthermore, any money in your Roth IRA that is not spent on college expenses can remain indefinitely in your account to fund your retirement.

More About the Disadvantages of a Roth IRA

The cap on annual contributions to a Roth IRA are relatively low ($6,000 for people younger than 50 and $7,000 for those aged 50 and over). Furthermore, if you earn too much money, you may be disqualified from contributing to a Roth IRA. 

Whereas contributions to some state 529 college plans are tax-deductible, this is not the case for Roth IRA contributions. You always fund your Roth IRA account using post-tax dollars. 

Although the money in your Roth IRA account is not counted for financial aid purposes, your withdrawals are seen as income (even if you only withdraw your contributions). And that can jeopardize how much financial aid you will receive.

Furthermore, when you use a retirement account for college savings, you reduce the amount of money available for your retirement. If using a Roth IRA to save for college adversely affects your retirement savings (because you bump up against the annual contribution limit), then you may want to use a 529 plan instead.  

A 529 College Savings Plan vs. a Roth IRA: Which Should You Use to Save for College?

A 529 college savings plan vs. a Roth IRA - which should you choose?

There are several advantages to using a Roth IRA to save for college. Since you fund your Roth IRA and 529 plans with post-tax dollars, your contributions and earnings grow tax-free. 

It can be difficult to choose between a 529 plan and a Roth IRA. However, you can use both vehicles to save for college – as long as you can afford to do so. That would be a good strategy. You can first withdraw money from your 529 plan and then go to your Roth IRA for any remaining expenses. That way, you keep as much money as possible in your Roth IRA to grow towards funding your retirement. 

Let Riegelwood Federal Credit Union Help You Fund Your Future

We have discussed choosing between a 529 college savings plan vs. a Roth IRA. It’s up to you to choose which option you would like to use – or you could use both to save for college. Riegelwood Federal Credit Union is your partner to help you to secure you and your family in the future. Whether you are saving for college, retirement, or some other milestone, or investing, we can help you. Contact us today to discuss how we can help you achieve financial independence and wealth creation.