Saving for College: 529 vs Roth IRA. Part One

Tina Haapala |

By Gary Silverman, CFP®

 

When it comes to saving for college there are several options available. Which works best for you? Should you open a 529 plan or a  education savings account? What about opening a Roth IRA? Each type of account has its benefits and drawbacks, and most are better than burying some cash in the backyard, so what works best for you depends on your specific savings goal.

Much like a Roth IRA, 529 plans allow for tax and penalty free growth and withdrawals. Unlike a Roth,529 funds need to be used for qualified educational expenses in order to avoid taxes and a 10% penalty. The IRS defines qualified educational expenses as tuition, fees, room and board (if enrolled at least half time), books, supplies, and equipment (including a computer and computer software required for classes). Failure to use the funds for these purposes will result in the gains being taxed as ordinary income and the 10% penalty being assessed. This is where the first drawback of 529 plans arises. The majority of parents who save for their child’s education begin when the child is very young. Nobody knows if three-year-old little Sally is going to go to college or not. If she decides get a job straight out of high school instead of going to college the owner of the plan will owe some money for taxes and penalties. If Sally has a little brother or sister, the funds can be transferred tax-free to them, but that doesn’t help single-child families.

Roth IRAs are a lot more flexible when it comes to withdrawals. As long as the account has been established for five tax years and the owner is at least 59 ½ the funds can be withdrawn tax and penalty free for any purpose. No worries though if you aren’t 59 1/2, contributions are always the first thing to be withdrawn from a Roth and can be withdrawn any time free of taxes and penalties. Roths also allow for earning to avoid the penalty if withdrawn early for certain situations including qualified educational expenses. In other words, you would still get taxed on the earnings, but you wouldn’t owe a penalty.

So why not just use a Roth IRA for college savings? One reason is that 529 plans allow for greater contributions than a Roth. The current annual contribution limit for IRAs is set at $5,500. The limits for 529 plans depend on the state that governs the plan, but they are much higher than $5,500. As a rule of thumb most advisors use the annual gift tax exclusion as the limit for 529 plans. This is almost double the limit of IRAs and if you and your spouse split the gift that’s an extra $14,000 that can be contributed each year. The drawback here is that unlike a Roth, where contributions are withdrawn first, 529 plans don’t just take out contributions first. Withdrawals are prorated between contributions and gains. Meaning there isn’t a way to make a non-qualified withdrawal without the taxes and penalties.

Next time, we will continue the discussion of pros and cons of these plans for college savings to help you determine what makes sense for you.

 

This article was published in the Wichita Falls Times Record News on November 8, 2015.