College Saving: How Does a 529 Plan Compare to a Roth IRA?
529 plans were created back in 1996, to give individuals and families a tax-advantaged way to save for college. Roth IRAs were created shortly thereafter as a tax-advantaged strategy for retirement savings. But a funny thing happened along the way — some parents adopted the Roth IRA as a college savings tool.
Tax Benefits and Use of Funds
Roth IRAs and 529 plans have a similar tax modus operandi. Both are funded with after-tax dollars, contributions accumulate tax deferred, and qualified distributions are tax-free. But in order for a 529 plan distribution to be tax-free, the funds must be used for college or K-12 education expenses. By contrast, a qualified Roth distribution can be used for anything — retirement, college, travel, home remodeling, and so on.
In order for a distribution from a Roth IRA to be tax-free (i.e., a qualified distribution), a five-year holding period must be met and one of the following must be satisfied: The distribution must be made:
- after age 59;
- due to a qualifying disability;
- to pay certain first-time homebuyer expenses; or
- by your beneficiary after your death.
For purposes of this discussion, it’s the first condition that matters: whether you will be 59½ or older when your child is in college. If the answer is yes (and you’ve met the five-year holding requirement), then your distribution will be qualified and you can use your Roth dollars to pay for college with no tax implications or penalties. If your child ends up receiving a grant or scholarship, or if overall college costs are less than you expected, you can put those Roth dollars toward something else.
But what if you’ll be younger than 59½ when your child is in college? Can you still use Roth dollars? You can, but your distribution will not be qualified. This means that the earnings portion of your distribution (but not the contributions portion) will be subject to income tax.
Note: Just because the earnings portion is subject to income tax, however, doesn’t mean you’ll necessarily have to pay it. Non-qualified distributions from a Roth IRA draw out contributions first and then earnings, so you could theoretically withdraw up to the amount of your contributions and not owe income tax.
Also, if you use Roth dollars to pay for college, the 10% early withdrawal penalty that normally applies to distributions before age 59½ is waived. So the bottom line is, if you’ll be younger than 59½ when your child is in college and you use Roth dollars to pay college expenses, you might owe income tax (on the earnings portion of the distribution), but you won’t owe a penalty.
If 529 plan funds are used for any other purpose besides the beneficiary’s qualified education expenses, the earnings portion of the distribution is subject to income tax and a 10% federal tax penalty.
Financial Aid Treatment
At college time, retirement assets aren’t counted by the federal or college financial aid formulas. So Roth IRA balances will not affect financial aid in any way.
Note: Though the aid formulas don’t ask for retirement plan balances, they typically do ask how much you contributed to your retirement accounts in the past year, and colleges may expect you to apply some of those funds to college.
By contrast, 529 plans do count as an asset for parents under both federal and college aid formulas.
With a Roth IRA, your investment choices are virtually unlimited — you can hold mutual funds, individual stocks and bonds, exchange-traded funds, and REITs, to name a few.
With a 529 plan, you are limited to the investment options offered by the plan, which are typically a range of static and age-based mutual fund portfolios that vary in their level of risk. If you’re unhappy with the market performance of the options you’ve chosen, under federal law you can change the investment options for your existing contributions only twice per calendar year (though you can generally change the investment options on your future contributions at any time).
Eligibility and Contribution Limits
Unfortunately, not everyone is eligible to contribute to a Roth IRA. For example, your income must be below a certain threshold to make the maximum annual contribution of $5,500 (or $6,500 for individuals age 50 and older).
By contrast, anyone can contribute to a 529 plan; there are no restrictions based on income. Another significant advantage is that lifetime contribution limits are high, typically $300,000 and up. And 529 plan rules allow for large lump-sum, tax-free gifts if certain conditions are met — $75,000 for single filers and $150,000 for married joint filers in 2018, which is equal to five years’ worth of the $15,000 annual gift tax exclusion.
Note: One final consideration to remember is that leveraging a Roth IRA for college expenses does sacrifice retirement savings. As parents weigh the advantages of 529 plans and Roth IRAs, it would be unwise to forget the potential detrimental effects of depleting one of the most beneficial retirement plan vehicles – the Roth IRA.
Please feel free to contact us with questions related to financial planning for college and other life events.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2018
Material discussed in this communication is meant to provide general information and should not be acted on without obtaining professional advice tailored to you or your company’s individual and specific needs. Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used by any person or entity, for the purpose of (i) avoiding penalties that may be imposed on any taxpayer or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. This information is for general guidance only and is not a substitute for professional advice.
The information contained herein should not be construed as personalized investment advice. Investment in securities involves the risk of loss, and past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this document will come to pass. Historical performance results for investment indexes and/or categories generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. There can be no assurances that your portfolio will match or outperform any particular benchmark.
Information presented was obtained from sources deemed qualified and reliable; however, MFA makes no representations as to accuracy, completeness, suitability, or validity of any information within this communication and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Any forward-looking statements are believed to be reasonable; however, MFA gives no assurance that such expectations will prove to be correct.