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Roth IRA vs 529 Plan: What is The Best For You?

date November 30, 2021 time 6 min read 194 views

If you’re looking for smart college savings vehicles for your children’s education, weighing up Roth IRA vs 529 plan can help you deal with the cost of college rising year over year. So, 529 plan vs Roth IRA, which is better for you? Let’s dive in. 

You already know the cost of sending your children to a 4-year college is expensive and it has been rising, even faster in recent years. So, besides making a college budget plan, many parents are looking for cost-saving ways to help their children pursue higher education. 

Roth IRA vs 529 Plan, which is the best option?
Roth IRA vs 529 Plan, which is the best option? (Source: Pixabay)

You might consider two common options: the Roth IRA vs 529 Plan. Both are tax-advantaged savings vehicles that you can use to save for future education costs, instead of taking out student loans. In this article, we will compare the 529 plan vs Roth IRA so that you can choose the better for you and your family.

1. What is a 529 plan?

A 529 plan is specifically designed to cover post-secondary education costs including tuition, fees, books, room and board, computers, and related services like internet access. Annual distributions of up to $10,000 per beneficiary for K-12 education are also allowed under the 2017 Tax Cuts and Jobs Act (TCJA).

529 plans have two primary types:

  • Prepaid tuition plans: You can pay in advance for the beneficiary’s expenses at participating universities for future use. This type typically does not cover room and board.
  • Savings plans: Similar to a Roth IRA. These allow you to open an investment account to pay for qualified college expenses, including tuition as well as room and board.

2. What is a Roth IRA?

While a 529 plan is designed to pay for education expenses, a Roth IRA is also used for college though it is technically a retirement account. It is a type of IRA that you can save money in a tax-advantaged account and then withdraw it tax-free after you turn 59½ years old. This means you contribute after-tax money today to have more income at your disposal after your retirement. However, unlike with traditional IRAs, you will not receive a current tax deduction for contributions made to a Roth IRA.

More and more parents are asking how to save for future education costs.
More and more parents are asking how to save for future education costs.(Source: Pixabay)

3. Roth IRA vs 529 Plan: How the tax benefits work

With a 529 plan, you will not owe taxes as long as you follow the rules: the money you withdraw goes to qualified education costs. Otherwise, you may owe taxes and a 10% penalty on investment earnings. 

When comparing the 529 plan vs Roth IRA, one of the biggest differences is that you can not simply bank those earnings for retirement if your son or daughter decides to forgo college. The flexibility of a Roth IRA vs a 529 plan is more appealing since you can use your funds to prepare for your retirement with a Roth IRA if your children do not attend college. Additionally, the Roth allows you to withdraw money for any reason whenever you want with no taxes, penalties, and paying for college education expenses.

If you take any growth or interest out before you meet both the rules of Roth IRA, you may be in charge of the ordinary income tax and a penalty of 10%. This penalty is waived if the distribution was made to pay for higher education expenses.

4. Roth IRA vs 529 Plan:  Income and contribution limits

A 529 plan:

According to some of the financial advisors in Boston, for 529 contributions, individuals of all income levels can enjoy the benefits and no contribution limits. Individuals and couples can contribute up to $15,000 and $30,000 respectively making a joint contribution each year without incurring gift taxes or using the lifetime gift tax exclusion. 

529 plans also provide an opportunity to reduce your gift tax exposure through gifting by electing to spread a contribution between $15,000 and $75,000 over five years. There are also lifetime aggregate contribution limits that vary from state to state, ranging from $235,000 to over $500,000.

Both 529 plans and Roth IRA contributions will not give you a tax deduction this year. (Source: Pixabay)

Roth IRA

While the IRS introduces a new 401k 2022 contribution limit IRS each year, changing how much taxpayers can save in their accounts, there are no aggregate contribution limits on a Roth IRA. In 2021, the maximum contribution of married couples filing jointly with a Modified Adjusted Gross Income (MAGI) less than $198,000 ($125,000 for individuals) is $6,000, ($7,000 if age 50+). 

Contributions are phased out for incomes of $125,000 to $140,00 for individuals filing or $198,000 to $208,000 for couples. Third parties cannot contribute to a taxpayer’s Roth IRA. 

5. Roth IRA vs 529 Plan: Free Application for Federal Student Aid effect

A 529 plan

The value of a 529 college savings plan is considered as a parental asset on the FAFSA. Only a maximum of 5.64 percent of the parental asset value will be used to pay for college expenses. It is much lower than accounts that are considered the student’s assets.

Remember that this favorable treatment does not apply to 529 plans owned by anybody else (grandparent, relative, friends, etc). Nevertheless, distributions will be counted as untaxed income to the beneficiary on the FAFSA. Untaxed income on the FAFSA reduces aid eligibility by about fifty percent of the distribution amount.

Roth IRA

If you have ever read some of the best books for financial literacy, they might mention that Roth IRA is not reported as an asset on the FAFSA, which means the value of your Roth IRA will not affect your chances for financial aid eligibility. However, a Roth IRA distribution may be considered as income on the FAFSA. If you take a non-qualified distribution, the taxable income is added to your adjustable gross income (AGI). 

6. Roth IRA vs 529 Plan: Investment options

A 529 plan: The investment accounts give people limited options in mutual funds, different stock, or bond funds; however, you do not need to pay taxes on your investment plans or when you cash out to pay for qualified educational expenses.

Roth IRA: While with 529 plans, individuals are only able to choose between a few different stock and bond funds, Roth IRA provides a wide variety of investment options like a brokerage account including stocks, bonds, mutual funds, exchange-traded funds, etc. However, if you need that money for your child’s college in the next few years, you should avoid type of high investment risks to cover the full cost of a college education.

Exposing yourself to too much risk could lead you to losing all your money
Exposing yourself to too much risk could lead you to losing all your money (Source: Pixabay)

Additionally, Roth IRA has a big drawback when investing your college savings in a brokerage account: long-term capital gains tax. Depending on your income tax bracket, you could pay up to 20%. For example, you have invested $100,000 for college in a brokerage account, but after paying taxes on it,  you could end up with only $85,000.

Roth IRA vs 529 Plan: Which is better for you?

Choosing a better option between a 529 plan and a Roth IRA may be difficult for you. But instead of leveraging them, why don’t you take advantage of combining both, provided you can afford them. This is a good investment strategy and your kids will thank you when they graduate without the financial burden of excess student loans.

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