There are several options available when it comes to saving for a loved one's college education. Two popular savings vehicles include a 529 plan and a Roth IRA. Here's a rundown of each account type and the benefits and drawbacks of each.
529 plans can help save enough for any college education
529 plans are administered by individual states, and many states' plans allow for rather high contributions -- over $400,000 in some cases. Contributions are not tax-deductible, but any withdrawal for qualified education expenses will be tax-free.
The main drawback to using a 529 plan for college savings is that the money must be used for qualifying higher-education expenses, which include:
- Tuition and fees.
- Room and board.
- Required textbooks.
- Electronics (such as computers, tablets, and smartphones).
Some costs related to attending college don't qualify, including (but not limited to):
- Room and board, beyond the cost of on-campus housing.
- Transportation and travel costs.
Any withdrawals that are used for non-qualifying purposes may be assessed a 10% penalty. Keep in mind that if you don't need all the money in the account for the beneficiary's college education, then the account can be transferred to another child or other relative. However, the money must be used for higher education in order to avoid the penalty.
Another drawback is that money in a 529 plan counts as assets when a student is filling out the FAFSA. In other words, if the student is the beneficiary of a 529, then it could negatively affect their eligibility for financial aid.
A Roth IRA for college savings?
You may not think of a Roth IRA as a college savings account, and technically you're right -- a Roth IRA is designed for retirement savings. However, there are some benefits to a Roth IRA that make it a great vehicle for college savings.
First and foremost, with a Roth IRA, you are free to withdraw your original contributions (but not any investment gains) at any time, for any reason, without paying a penalty. In other words, if you've contributed $40,000 to your Roth IRA over the years, then you can do whatever you choose with that amount of money. Whereas there is a clear list of acceptable expenses for money from a 529, withdrawals from a Roth IRA can be used for anything -- perhaps a new computer or a vehicle to get to and from school.
Secondly, college expenses are exempt from IRA early-withdrawal penalties. So you can withdraw your Roth IRA earnings penalty-free, so long as the account has been open for at least five years. If you're under 59 1/2, however, you'll still have to pay taxes on the distribution, even if there's no penalty.
Also, Roth IRA savings don't count as assets on the FAFSA, so they won't affect the student's eligibility for financial aid. Although the savings don't need to be counted for the FAFSA, any Roth IRA withdrawals must be accounted for in FAFSA documentation. Luckily, the FAFSA only tracks the last two years of income, so consider waiting to make a withdrawal until late in your college career so that it won't affect any potential financial aid arrangements.
Finally, any Roth IRA funds that aren't used for college. If your student decides not to go to college, or does not use all of the funds in the 529, then you can simply leave the money in the account to grow until you retire.
The main drawback of using a Roth IRA to save for college is the lower contribution limits. We mentioned earlier that you can contribute a total of $400,000-plus to a 529 plan in many states. Roth IRA contributions, on the other hand, are currently limited to $5,500 per year, or $6,500 for savers over age 50. Further, in order to qualify to make a full contribution to a Roth IRA, your income must be less than $184,000 in 2016 for married couples or less than $117,000 for singles. There is a "backdoor" method of contributing for higher-income individuals, but it is a bit of a hassle.
Which one is right for you?
The right choice for you depends on several factors. If you need to save an amount that's in six-figure territory, then the 529 plan is probably best. On the other hand, if you're not 100% sure the student will need the money for college, then a Roth IRA can make more sense. The best course of action is to look at your situation and decide which one works best for you -- and if the answer is "both," you could always use a combination of the two.
Learn even more about Roth IRAs (and their traditional-IRA counterparts) by visiting our IRA Center.
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