Roth IRA vs 529 Plan: Which is Better for Setting Up a College Fund?

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A parent’s first instinct is to look out for their children and provide them with the best education possible. But if they fail to do so due to a lack of funds available to them, it can be quite disheartening. One of the primary reasons that parents save is for their children's college tuition. For a layman, college funding can be slightly confusing due to the number of financial instruments available to them to choose from. You may consult with a financial advisor to decide which option to go for and they can take you through the various pros and cons of each financial instrument. There are two instruments that are quite appealing and feasible: a Roth IRA and a 529 plan.

To make an informed decision, you need to weigh the advantages against the disadvantages of both. Below are the points you must consider while making your decision:

1. Flexibility in terms of investment opportunities

In a Roth IRA, investors can make use of their funds to fulfill their essential financial needs, their child's education being one amongst them. The primary purpose of setting up a Roth IRA is to save and invest money for retirement; however, the investor can choose to use the money either for themselves, their children’s education, or both. A greater degree of flexibility is afforded to investors in this case when compared to a 529 plan wherein the funds can only be used for the stated educational purposes. Though access to certain exemptions such as scholarships is available, the investors will be liable to pay taxes and penalties if the money is used for any purpose other than the one stated. Moreover, in the aforementioned scenario, any state income tax benefits would have to be returned.

2. Restrictions on earnings for a Roth IRA versus a 529 Plan

Parents using a Roth IRA to fund their child's college education have to face several restrictions when it comes to earnings. Individuals belonging to a higher-income bracket cannot invest in a Roth IRA. Additionally, a single or a married taxpayer filing their taxes separately cannot breach an income threshold of $139,000. For married couples filing their taxes jointly, the income limit is $206,000. However, in the case of 529 plans, no such restrictions are placed on investors.

3. Limitations on contributions for funding college education

If you plan on using a Roth IRA to fund your child's college education, there are limitations on contributions you can make to your Roth IRA. A single or a married taxpayer can contribute $6,000 if they are earning or less, while a married couple (filing jointly) or a widow/widower can also contribute $6,000 if they are earning up to $196,000. An individual over the age of 50 can contribute up to $7,000. In addition, an individual can contribute if he/she has earned their income during the same accounting year, which means that only the primary beneficiary is permitted to contribute to the account. For a 529 plan, individuals can contribute up to $15,000, whereas the limit goes up to $30,000 for joint taxpayers. Moreover, a contribution of up to $75,000 can be made as well which is equal to a 5-year worth of contributions in a single year, provided certain conditions are met.

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4. Restrictions on investments for a Roth IRA versus a 529 Plan

No form of federal or state restrictions is placed on investments in Roth IRAs. However, that is not the case when it comes to 529 plans. There are different investment policies depending upon each state. Some states tend to prefer conventional investment policies that may play spoilsport with the financial goals of investors. This is because the main objective of any form of investing is earning good returns, which can get defeated when conservative investment guidelines are followed.

5. Tax advantages for a Roth IRA versus a 529 Plan

In a Roth IRA, an individual can withdraw the original investment amount without having to pay any taxes or penalties at any point in time. Also, the earnings on investment can be withdrawn without bearing any penalty or tax provided you do so after completing 59.5 years of age. So, this means that you can take out funds for educational purposes from a Roth IRA without attracting any taxes or penalties. Additionally, you can avoid paying any tax on distributions if you do not withdraw the complete amount of the original principal investment.

That however is not the case with 529 plans. When the funds from a 529 plan are used towards the payment of qualified educational expenses, you will not have to pay any tax or penalty on withdrawals. Moreover, your earnings do not attract any tax liability. Also, you earn an extra state tax credit or deduction on investments made in a 529 account which is available in more than 30 states. However, if you withdraw money from the account for any purpose other than the qualified educational expense, you will have to pay taxes along with a penalty of 10%.

6. Implications of FAFSA for receiving financial support from the government

When it comes to Roth IRAs, the Free Application for Federal Student Aid or FAFSA does not consider the funds invested in them as part of the investors’ asset portfolio. This means that any investment made in these accounts would not negatively affect investors’ eligibility for receiving government financial support. However, when using funds from a Roth IRA for qualified educational expenses, those funds are considered as untaxed income by the FAFSA, which may affect the student’s eligibility for receiving additional financial aid for education.

Speaking of 529 college plans, investments made in these accounts are included as part of the asset value of the parents as per the FAFSA. This account value is included irrespective of the fact who has current ownership of the account be it the parents or the student. Moreover, up to 5.64% of the total value of the parents’ asset portfolio can be used to fund the college expenses when calculating the expected family contribution (EFC). This proportion rises to 20 percent when calculating the student’s assets which leads to a fall in the EFC. This is helpful in case the student requires additional financial support from the government.

To summarize

Choosing between a Roth IRA or a 529 college savings account is a vital decision that has far-reaching implications for your life as well as for your child's career. Both the accounts have their pros and cons. To pick one between them, you need to assess each aforementioned factor in its entirety and its effects on your financial situation. You can also consult with an experienced financial advisor who can help you choose the best option for you and your child. Use the free match tool to get connected with 1-3 fiduciary financial advisors that may be able to help you as per your financial requirements.

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The blog articles on this website are provided for general educational and informational purposes only, and no content included is intended to be used as financial or legal advice.
A professional financial advisor should be consulted prior to making any investment decisions. Each person's financial situation is unique, and your advisor would be able to provide you with the financial information and advice related to your financial situation.