Which is best: 529 college savings plan or Roth IRA?
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By Kathryn Flynn

April 12, 2021

The average cost of sending a child to a 4-year public university is over $75,000 today, which means if you have a young child you can expect to pay over $150,000 when their time comes. If you have more than one child or choose a private school, your total college costs could easily end up totaling more than the price of your home. Fortunately, there are tax-advantaged accounts that can help families save for college. Let’s compare two common ways to save for college: 529 vs Roth IRA. 

Compare college savings options

How the tax benefits work:

Roth IRA

In a Roth IRA, the principal portion (the amount you put in) can be withdrawn tax-free and penalty-free at any time for any purpose. Earnings in the account grow tax-free and can be withdrawn tax-free and penalty-free only after you reach retirement age. A key benefit of Roth IRAs is that distributions are not taxed as earnings until the entire principal balance is withdrawn. That means you can take out as much as you put in tax-free to pay for college and withdraw the earnings portion tax-free when you turn 59 1/2.

If you withdraw earnings from your Roth IRA account before you reach retirement age, you will be subject to income tax and a 10% penalty on the earnings.

There is an exception to the early withdrawal penalty if the funds are used to pay for qualified higher education expenses. However, you will owe income taxes on the earnings portion of the early distribution. 

529 college savings plan

A 529 plan offers tax-deferred investment growth and tax-free withdrawals when the money is used to pay for qualified education expenses.

Qualified education expenses for 529 plans include:

  • College costs such as tuition, fees and room and board
  • Up to $10,000 per year in K12 tuition
  • $10,000 in student loan repayments

If you take a non-qualified 529 plan withdrawal, the earnings portion will be subject to income tax and a 10% penalty. Unlike a Roth IRA, every distribution contains an earnings portion and a contribution portion. 

Residents in over 30 states can also claim an additional state tax credit or deduction for 529 plan contributions

Income and contribution limits:

Roth IRA

In 2021, married couples filing jointly with a Modified Adjusted Gross Income (MAGI) less than $198,000 ($125,000 for individuals) can contribute the maximum amount of $6,000 to a Roth IRA. Couples with an MAGI of $208,000 or greater ($140,000 for individuals) are ineligible for a Roth IRA. If you are over 50 you may also be able to make a catch up contribution of $1,000 per individual.

529 college savings plan

Individuals of all income levels can enjoy the benefits of a 529 account. What’s more, there are generally no annual contribution limits and deposits up to $15,000 ($30,000 for married couples filing jointly) will qualify for the annual gift tax exclusion in 2021. If you’re looking to reduce your gift tax exposure through gifting, you can elect to spread a contribution between $15,000 and $75,000 over five years. This is a common estate planning strategy for grandparents who want to ensure their legacy is being put to good use.

529 plans do have lifetime aggregate contribution limits that vary by state, ranging from $235,000 to over $500,000.

Effect on federal financial aid:

Roth IRA

Retirement accounts are not considered assets on the Free Application for Federal Student Aid (FAFSA), which means the value of your Roth IRA won’t hurt your chances for financial aid eligibility.

A Roth IRA distribution, however, may be reported as income on the FAFSA. If you take a taxable distribution, the taxable income is added to your adjustable gross income (AGI). Qualified distributions are reported as untaxed income. 

529 college savings plan

The value of a 529 college savings plan, whether it is owned by a dependent student or one of their parents, is considered a parental asset on the FAFSA. When determining the EFC, only a maximum of 5.64 percent of a parent’s assets will be used to pay for college expenses. This is much lower than accounts that are considered the student’s assets, which are assessed at 20 percent. Lower EFC means more financial aid.

Withdrawals from parent- or student-owned 529 accounts are excluded from federal income tax return and do not have to be added back to base-year income on the following year’s FAFSA. Keep in mind that this favorable treatment does not apply to 529 plans owned by grandparents or other relatives.

Summary: 529 vs Roth IRA

 

529 Plan

Roth IRA

Tax Benefits

Tax-deferred growth and tax-free distributions for qualified education expenses

Return of contributions is tax-free, funds can be completely withdrawn tax-free at retirement

Income Limits

None

$198,000 to $207,999 (married)

 

$125,000 to $139,999 (single)

Annual Contribution Limits

None, contributions qualify for annual $15,000 gift tax exclusion

$6,000 ($7,000 for age 50 and older)

Effect on Financial Aid

5.64% of parent-owned account is counted as an asset

Distributions may be reported as income

ORIGINAL POST: 01/13/2015; UPDATED 4/12/2021

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