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529 vs Roth IRA: Which is the better choice to save for college?

Saving for a child’s education is toward the top of the list of financial goals for most young families.   While a 529 account is perhaps the most popular funding vehicle for college, I frequently see the argument that the Roth IRA is a superior option.  The primary reason cited is the risk that you'll pay a 10% penalty and taxes if your child earns a scholarship or decides against college altogether.  With a Roth, contributions can be withdrawn anytime without taxes or penalties. 

So today we have a head to head matchup pitting the 529 against the Roth.  I’ll layout some of the primary criteria that drive the decision and highlight key advantages and disadvantages of both accounts.

How much can I contribute each year?  

529: While there is technically no annual contribution limit, Federal Law states that the balance in a 529 account cannot exceed the expected cost of higher education.  This amount varies by state, currently ranging from $235,000 - $539,000.  If your balance is above the expected cost for your state, you don’t have any penalties to worry about, you just won’t be able to make additional contributions….and quite frankly, you probably shouldn’t.  The other important consideration is the potential for gift taxes.  Click HERE for a detailed explanation of how large your contributions can be before any potential gift taxes issues are triggered.  There are also no income phase out limits, so high earners can also reap the benefits of the 529.

Roth: Your ability to contribute to a Roth depends on your household income.  The phase out ranges are between $122,000 - $137,000 (single) or $193,000 - $203,000 (married filing jointly).  If your income is below the low end of the range, you can contribute the maximum, which is $6,000 for 2019 ($7,000 if you are age 50 or older).  If your income is higher than the top end of the range, you are not able to contribute at all.   Click HERE  for a more detailed breakdown of the income phase outs for each filing status. 

Winner:  The 529 is clearly a superior option due to its lack of both annual contribution limits and income phase out restrictions.

What if my child gets a scholarship or other financial aid?

529: In the case of a scholarship, non-qualified withdrawals up to the amount of the tax-free scholarship can be taken out penalty-free, but you'll have to pay income tax on the earnings. As Savingforcollege.com founder Joe Hurley likes to say, "the scholarships have turned your tax-free 529 investment into a tax-deferred 529 investment”.  

There are also several alternative uses for a 529 balance that would also be tax free withdrawals:

1.You can change the beneficiary:  If you have more than one child, you can change the beneficiary to a sibling of the original beneficiary.  You can also name your parent, nephew, niece, or grandchild.  You can even name yourself as beneficiary if you have plans to go back to school.

2.There is no time limit on a 529: the balance could grow tax free for years and if one of your kids decides to go to graduate school, you can help them avoid piling up student loans.  

3.With the change in tax law in 2018, you can use up to $10k per year for private elementary and high school tuition. 

Roth: Qualified distributions can be taken anytime without taxes or penalties.  Click HERE  for a summary of qualified Roth distributions.  

In both cases, any contributions can be withdrawn without taxes or penalties since both accounts are funded with after-tax dollars.  It’s only the earnings that are potentially at risk of taxes and/or penalties.

Winner:  The Roth wins due to greater flexibility on usage of the funds, but the wide range of options to re-purpose the 529 make this a rather narrow margin of victory in my opinion.

Which account offers better investment options?

529: There is a wide range of plans and providers and beauty really is in the eye of the beholder here.  I think it’s fair to say that with minimal research time on your part (or by enlisting the help of an advisor), you will find many plans that have a menu of options that enable you to choose the right mix of investments for your situation and risk appetite.  In terms of limitations, you will not be able to choose individual stocks within a 529, you will have to choose stocks funds or ETF’s.   One other important note here is that these plans typically limit the frequency that you can change investment options (usually 2 times per calendar year).  While some might point to that as a disadvantage, I view that “limit” as a blessing in disguise.  In most investing scenarios, the best strategy is buy and hold and I think that is true here as well.

Roth:  The full universe of investment options are available.  With very few exceptions, you should be able to invest in whichever stocks, bonds, ETF’s, REIT’s, etc., that you would have access to in a regular brokerage account.  

Winner:  This one is not as clear cut.  The Roth gives a larger universe of investment options and does not limit how frequently you can change holdings, which should give it the edge.  But if we reframe the question to say “which gives a higher probability of investment success”, I would favor the 529 simply because it greatly reduces the likelihood of major investment mistakes.  You can’t bet on Facebook stock, you can’t trade frequently and rack up transactions costs, and because of this you are much more likely to make your allocation decisions and “set it and forget it”.   Both sides have merit, but I vote for the 529 on this criteria.


Which account is the best choice?

Looks like it’s time to get to the punchline.  To this point, we have spent our collective energy on the finer details of these accounts to help you gravitate toward your preferred option.  As with all big financial decisions, I think it’s important to pause, step back and think about the big picture and how this one decision fits into your overall financial life.  If a client were to approach me and ask for my opinion on which account was the better for her situation, my first reaction would be “before we even consider using an account that is designed for retirement to fund college expenses, we have to assess your progress toward funding your retirement through other means”.   Put simply, your retirement should be a higher priority on your list than your child’s education.  

Many people would take issue with this position…..it’s normal to put the needs of your kids ahead of yourself and in most cases the college bills are going to arrive well before you ride off into the sunset of retirement.   However, even the most prestigious (and expensive) college will not require nearly the funding that a 20-30 year retirement will demand.  Secondly, there are no grants, scholarships, or loan programs to finance your golden years.  You might not like the thought of your child saddled with student loans, but compare that to you and your spouse moving in with them down the road because you have outlived your savings.

If you have substantial retirement assets, between your qualified accounts, defined benefit pensions, estimated social security benefits, and other net worth (taxable savings, home equity, inheritance, etc), using a Roth IRA to save for your children’s education can be a perfectly good choice.  I just think when most families get a realistic estimate of how much money they will need in retirement, they will correctly decide to maximize their Roth contributions with the intent to actually use those proceeds for retirement.  When they turn the page to focus on their kid’s college education, the 529 will be waiting for them with open arms.  

If you are just starting the process of saving for college, Click HERE to access a vast array of information on the subject.  You can learn about the various account types, locate plans and enroll, estimate how much you need to save,  learn how financial aid works, and find resources on practically anything under the big umbrella of education funding.  

Having all of this information can be empowering, but in some cases it may feel overwhelming.  If you have any questions or would like assistance in planning for your child’s education, please click HERE  to send me a note or to book a complimentary consultation.