There are two tax-smart ways to set aside money for college: 529 plans and Roth IRAs. While 529 plans are designed to pay for education, you can also tap a Roth IRA for college even though it’s intended for retirement.
Key Takeaways
- 529 savings plans and Roth IRAs are both tax-advantaged options to save for college, and some families use both options.
- For 2021 and 2022, you can contribute up to $6,000 a year ($7,000 if you’re age 50 or older) to a Roth IRA.
- For 529 plans, there is contribution limit set by the IRS, as long as certain requirements are met.
What Is a 529 College Savings Plan?
A 529 plan is a lot like a Roth IRA, but it’s designed for education expenses instead of retirement. Originally, you could use a 529 to cover only post-secondary education costs. But it was expanded to include up to $10,000 per beneficiary for K-12 education under the Tax Cuts and Jobs Act (TCJA).
Two primary types of 529 plans are:
- Prepaid tuition plans: These allow you to pay in advance for the beneficiary’s expenses at designated schools.
- Savings plans: These are tax-advantaged savings accounts, similar to IRAs.
All 529 plans are set up at the state level but you don’t have to be a resident of a particular state to enroll in its plan. For example, if you live in Florida, it’s perfectly okay to enroll in California’s plan.
If the original beneficiary doesn’t use the money for education, you can change beneficiaries within a fairly wide list of family members, including yourself. And, since the passage of the SECURE Act in December 2019, you can now pay off $10,000 of college debts each for the beneficiary and the beneficiary’s siblings from unused 529 funds.
Before you move forward, look hard at the pros and cons of 529 savings plans.
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Contributions to your state’s 529 may deliver advantages on your state income taxes.
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Contributions and earnings grow tax-free.
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There are no income or age limits.
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Large contributions are permitted, depending on state rules—even $75,000 at once to front-load a plan and still avoid gift tax.
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They have an easy, set-it-and-forget-it investment model.
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There are no taxes on withdrawals used for qualified education expenses.
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You can switch beneficiaries and use some of the money to pay off college loans.
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You have to use the money for the intended purposes or pay a penalty to get it back.
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Investment options are limited.
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You need to check plans carefully for good performance and fees.
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Plans are limited to one beneficiary at a time; families with multiple children may need more than one.
Advantages of 529 Plans for College
Contributions aren’t deductible from your federal taxes. However, if you live in one of the more than 30 states that offer state income tax advantages for using that state’s plan, you may get a full or partial tax deduction or credit.
Your money grows tax-free in the account. And you won’t be taxed when you withdraw money from the plan, provided you use it for qualified education expenses.
There are no income or age limits for 529 plans. Annual contribution limits are set by the state, but to avoid the federal gift tax, you’ll need to give no more than $15,000 per year, per beneficiary.
One key exception: If you are fortunate enough to have wealthy family members, they can front-load the 529 by contributing five years of the gift-tax maximum at one time ($75,000 per person for each beneficiary/account) without paying gift taxes. Do that early, and the money can grow throughout childhood and pretty much take care of college.
Finally, a 529 plan isn’t a complicated investment product to manage. It’s largely based on a “set it and forget it” model where you select a certain track, contribute regularly, and watch the balance grow.
Disadvantages of 529 Plans for College
First, because it’s specifically for education expenses, you have to use the money for the intended purpose or pay the price—literally. Although only the earnings portion is subject to taxes and penalties, you pay normal income tax and a 10% penalty to take the money back.
There are ways to claim an exemption from the 10% penalty, but you’ll still be on the hook for the taxes. If nothing else, you can make yourself the beneficiary and use the funds to further your own education.
Second, the investment options are limited. Offers vary widely among states, and some state 529 plans perform much better than others. If you’re a savvy investor, you may not like the options you’re given. Make sure you also compare fees.
What Is a Roth IRA?
You may know the Roth IRA as a retirement vehicle, but you can also use it to save for college.
Young investors—including teens—can really take advantage of a Roth IRA because they pay taxes now when they’re likely in a low tax bracket.
You can contribute to a Roth IRA at any age, as long as you have “earned income” (taxable income) and don’t make too much money. Unlike traditional IRAs, there are no required minimum distributions (RMDs) with Roth IRAs during your lifetime. That means you can keep your money in the account if you don’t need it.
Given how good a Roth IRA is for retirement savings, does it make sense to use it to fund college?
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Contributions and earnings grow tax free.
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Contributions (but not earnings) can be withdrawn at any time—income tax and penalty free.
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Once you reach 59½, all money can be withdrawn tax and penalty free to help with children and grandchildren’s expenses.
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The rest of the Roth money can remain in the Roth to fund your retirement.
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The annual contribution is low, compared to what you can contribute to a 529.
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There’s no state income tax deduction for Roth contributions.
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Roth withdrawals count as income for financial aid purposes and can affect how much aid will be offered.
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Giving away Roth money cuts retirement funds—and Roth savings come tax free when you withdraw them, with no required minimum distributions.
Advantages of Roth IRAs for College
Many of the advantages that make a Roth IRA a great way to save for retirement make it an ideal way to save for college, too.
Like the 529, there is no income tax deduction when you contribute to a Roth IRA. Instead, your contributions and earnings grow tax-free. And because you’ve already paid your taxes, you can withdraw contributions at any time, for any reason, tax-free.
Many families use money from a Roth IRA to pay for at least a portion of their children’s college expenses. The real magic of the Roth IRA happens if you waited until later in life to have kids or you’re saving for grandkids.
Once you reach 59½ (and it’s been at least five years since you first contributed to a Roth), all of your withdrawals—earnings as well as contributions—are tax-free. That means 100% of your withdrawals can go to college expenses. If you’re not 59½ yet, withdrawals of earnings will be subject to income taxes, but not an early withdrawal penalty, as long as the cash is used for college expenses.
What’s more, any money you don’t end up spending on college can remain in the Roth to fund your own retirement.
Disadvantages of Roth IRAs for College
First, the annual contribution limit is low. For 2021 and 2022, you can contribute $6,000, or $7,000 if you’re age 50 or older. That means that over the course of 18 years, you could add up to $108,000, or $216,000 if you and your spouse both contribute to an IRA.
Generally speaking, both of you would have to contribute the full amount to fund a child’s college education on contributions alone.
Second, Roth IRAs do have income limits. That is if you’re single, your contribution limits being to phase out if you make $125,000 and above for 2021 ($129,000 for 2022). If you are single and make $140,000 or above ($144,000 for 2022) you’re ineligible for a Roth IRA. Meanwhile, those that are married making $198,000 and above for 2021 ($204,000 for 2022) will see phase-outs, while those making $208,000 in 2021 ($214,000 for 2022) and above are ineligible.
Third, unlike some 529 plans, there’s no state income tax deduction for Roth IRAs.
Fourth, money that’s inside a Roth isn’t counted for financial aid purposes. However, withdrawals are counted, and that can affect your financial aid package. That’s because withdrawals are counted as income, even though the money isn’t taxed.
Finally, by using a retirement account for college savings, you lower the amount of money you can save for your own retirement. If using a Roth to save for college impacts your retirement savings because you bump up against annual contribution limits, it might be better to use the 529.
How do I open a 529 plan?
Start with the list of all state plans on the SavingsforCollege.com website. All 529 plans are set up at the state level but you don’t have to be a resident of a particular state to enroll in its plan. For example, if you live in Florida, it’s perfectly okay to enroll in California’s plan. Still, opening one in your home state may have advantages. Once you’ve chosen your plan, complete the application. Create a savings goal and a budget that ensures you reach it. Set up your funding mechanism, such as direct deposits, then choose your investment options. Start saving.
What is a disadvantage of the 529?
Not many, but there are a few. You have to use the money for the intended purposes or pay a penalty to get it back. You need to check plans carefully for good performance and fees. Plans are limited to one beneficiary at a time; families with multiple children may need more than one.
So should I choose a Roth?
Not necessarily, as they also have disadvantages. For one thing, the annual contribution is low, compared to what you can contribute to a 529. There’s no state income tax deduction for Roth contributions. They also count as income on financial aid applications, and giving away Roth money cuts retirement funds.
Bottom Line
It can be difficult to choose between a 529 plan and a Roth IRA. But there’s nothing that says you can’t fund both, provided you’re financially able to do so. This can be a good strategy. You can use the money from the 529 first and then tap the Roth for any leftover expenses. Whatever money is left in the Roth can stay there for your retirement.