Roth IRA or 529 Plan: Which is the better college savings tool?

As a new school year begins in the fall, parents and grandparents of young kids and teens are likely to be thinking about higher education. Specifically, they are wondering about the best way to save for any future education expenses. In 2023, the average cost of a 4 - year public college is well over $100,000 for in-state tuition and over $223,000 for private universities! Not an easy amount to save up.

Fortunately, there are tax advantaged accounts that can help you save for college.  A Roth IRA and 529 Savings Plan are both excellent ways to save, but each has its own set of rules and characteristics.

Today on Coffee and Cash, we’ll dive into how Roth IRAs and 529 plans compare as options for college savings vehicles.  

Let’s start with the Roth IRA. 

One of the biggest benefits of a Roth IRA is that you are able to withdraw the contributions you made to the account any time without penalty or taxes, however, if you withdraw the earnings your contributions have earned, you need to ensure you satisfy certain criteria or risk potentially having to pay taxes and a penalty.  Let’s illustrate with an example.  If you contributed $10,000 to a Roth IRA and it has now grown to $12,000, at any time you can take out the $10,000 initial contribution with no penalty or taxes.  The $2,000 in earnings however will be subject to a 10% penalty and taxes if it is not categorized as a qualified distribution or qualifies for an exception.

For the purposes of this video which is focused on financing education expenses, it is important to know that education expenses which includes tuition, books, room & board and other necessary supplies, qualifies as an exception that allows you to access Roth earnings without a 10% penalty.  Note however, that those earnings will still be taxed as taxable income. 

In contrast, the 529 plan is a type of account designed specifically for savings towards college expenses.  Money contributed to the 529 plan grows and can be withdrawn tax free, provided the withdrawals are used for qualified education expenses.  It has a narrower focus than the Roth IRA, but if used for college, if probably the simpler type of account to maintain and manage. 

You may ask, why would I use my Roth IRA for college expenses?  This is a great question, as historically, a Roth IRA has been used mostly for retirement savings and not college expenses.  There are a few reasons to consider, namely that if the funds aren’t needed for college, the funds can remain in your Roth IRA for your own use and can continue to grow tax-free.  In addition, you can access the contributions in your Roth IRA at any time for whatever the reason, whereas withdrawals from the 529 not used for education-related expenses are going to be subject to taxes and penalties.  Flexibility is likely the biggest benefit of the Roth.

One of the biggest concerns historically with the 529 plan was that if your child didn’t go to college or use all the money in the 529 plan, it was not easy to get it out without penalty and taxes.  However, this concern has been reduced recently, as under the SECURE ACT 2.0, taxpayers are now permitted to roll up to $35,000 total in 529 plan dollars into a Roth IRA for their kids, starting in 2024.

A few other points of comparison as it relates to college funding and financial aid:

When considering financial aid eligibility, Roth IRAs are not reported as an asset on the FAFSA form, while 529 plans are and may reduce aid eligibility. On the flip side, distributions from the 529 plan, if owned by the parent or student are not counted as income whereas all distributions from ROTH IRAs count as income on the FAFSA which could reduce financial aid eligibility. 

In addition, some 529 plans like the NYS 529 plan offer a state tax deduction for contributions made to the 529 plan, whereas Roth IRA contributions are not eligible for tax deductions.

So, now that you are thoroughly confused, let me try summarize our thoughts on which vehicle to use.  It really all comes down to what you plan to use the funds for.  To summarize as simply as I can, I would suggest using a 529 for college savings and a Roth for retirement savings.  For college savings, the 529 plan is attractive as you get a state tax deduction (depending on your state!), can withdraw contributions and earnings tax-free if used for college and you are able to convert any unused 529 money into a Roth IRA for your kids.

For retirement, the Roth is an amazing vehicle.  You are able to grow your money tax-free for your lifetime, there are no mandatory required minimum distributions, and the account passes tax-free to your beneficiaries.  All around good deal.  For college however, still having to pay taxes on the earnings is a negative, and more importantly, I would prefer clients to be able to save as much as they can for their own retirement into Roth IRA’s.  Once money is take out of the Roth for college, it can’t be put back and you have essentially forfeit future tax-free growth on that money. 

Some clients may choose to fund both a Roth IRA and Section 529 plan. Contributing to one type of plan does not affect the other. The type of savings plan will depend on your goals and unique financial situation. If you would like to discuss which option may be the best tool for college and retirement for you, please give us a call at 518-406-5624 or book an appointment online at simmonscapitalgroup.com.

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Until next week, be well.