Unless you want your children graduating from college with five or six figures’ worth of debt, saving for college from the time they’re born is essential. There are a variety of ways to do that, but two of the more common ways are to use a 529 plan or a Roth IRA. Here’s a look at both products so you can decide which offers the best tools to help you reach that goal.
The 529 Plan
This account is specifically created as a vehicle to pay for “qualified education expenses.” That doesn’t necessarily mean attendance at a four-year college or university, but the 529 must be used for expenses to get an education after high school. For example, a qualified vocational school would be covered. (This list lets you know whether a school you are considering is included.) If the original beneficiary doesn’t end up getting post-secondary education, you can change beneficiaries within a fairly wide list of family members, including yourself.
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. If you live in Florida, for example, it’s perfectly OK to enroll in California’s plan. (See “Disadvantages,” below, to find out why you might want to do this.)
Although contributions aren’t deductible on your federal taxes, you won’t be taxed when you withdraw from the plan provided you use the money for qualified education expenses. 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.
There are no income, age or annual contribution limits for 529 plans, although you have to be careful of gift tax implications if you contribute too much in one year. If you do, talk to a tax professional as there can be ways around this.
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 elect a certain track, contribute regularly and watch the balance grow.
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 would have to pay normal income tax and a 10 percent penalty to take the money back. There are ways to claim an exemption from the 10 percent penalty, but you’ll still be on the hook for the taxes. If nothing else, as discussed above, you could 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, but if you’re a savvy investor, you may not like the options you’re given. Make sure you also compare fees.
The Roth IRA
You may know the Roth IRA as a retirement vehicle but you can use it for college saving as well. Like the 529, there is no income tax deduction when you contribute to a Roth IRA, so any contributions you make can be withdrawn without paying taxes or penalties, provided you’ve had it for at least five years.
Some people will withdraw their contributions at a later date to pay 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 all of your withdrawals—earnings as well as contributions—are tax free. That means 100 percent of your withdrawals can go to college expenses. If you’re not 59½ or older, any money you earned will be subject to income taxes but not an early withdrawal penalty as long as it’s used for college expenses.
What’s more, the money you don’t end up spending on college can remain in the Roth to fund your own retirement.
First, the annual contribution limit is low. As of 2017 you can only contribute $5,500—or $6,500 if you’re age 50 or older. That means that over the course of 18 years you could contribute up to $98,000, or $198,000 if you and your spouse both contributed. Generally speaking, both of you would have to contribute the full amount to fund a child’s college education on contributions alone.
Second, there’s no state income tax deduction.
Third, a Roth IRA isn’t a good vehicle if you plan to have friends and family contribute to the college fund. A 529 plan works better for that.
Finally, by using a retirement account for college savings, you’re lowering the amount of money you can save for your own retirement in those years. If using a Roth to save for college impacts your retirement savings because you bump up against annual contribution limits, it might be best to use the 529.