529 Plan vs. Roth IRA: What's the Difference?

Both can be used for higher education costs, but their rules differ

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A 529 plan and a Roth IRA are two common types of tax-advantaged investment accounts. While a 529 plan is designed specifically for higher education expenses, Roth IRAs are meant to be used for retirement savings. However, in some circumstances, a Roth IRA can also be used for education expenses, without penalty.

If you’re considering whether to invest in a 529 plan or a Roth IRA to help finance your child’s education or even your own, it’s important to know the differences between a 529 plan and a Roth IRA.

What’s the Difference Between a 529 Plan and a Roth IRA?

If you’re a parent or guardian seeking to invest money for your child’s education, you may be weighing a 529 plan versus a Roth IRA. A 529 plan, also known as a qualified tuition program (QTP), is a tax-advantaged investment account designed for education that is sponsored by a state or state agency. A Roth IRA is a type of individual retirement account that sometimes can be used for college savings as well.

In this article, we’ll focus on 529 savings plans, which are similar to a 401(k) or IRA that’s designed specifically for higher education. However, some states also offer 529 prepaid tuition plans, which allow you to pay tuition in advance at today’s rates.

You can open a 529 plan and name practically anyone as the beneficiary—your child, grandchild, or even yourself.

When you fund a 529 plan, your contributions aren’t tax-deductible, although sometimes your home state will offer tax incentives when you invest in its plan. However, the money grows tax-free. Your withdrawals then remain tax-free as long as you use the money for qualified higher education expenses.

You can withdraw up to $10,000 from a 529 plan for K-12 tuition per beneficiary per year under new rules enacted by the Tax Cuts and Jobs Act (TCJA), which passed in 2017. Under the SECURE Act of 2019, you also can make tax-free withdrawals of up to $10,000 from a 529 savings plan to repay student loans.

A Roth IRA is a retirement account you open for yourself. As with 529 plan contributions, your Roth IRA contributions aren’t tax-deductible. You can withdraw your contributions whenever you want, but you’ll pay income taxes and a 10% penalty when you withdraw your earnings early. Once you’re age 59 ½ and you’ve met the five-year rule, your distributions are tax-free.

Your Roth IRA can also double as a college savings vehicle. That’s because you can avoid the 10% early withdrawal penalty when you use the money for higher education expenses for yourself, your spouse, your child, or your grandchild. However, you’ll still pay income taxes on the earnings portion of a distribution for higher education.

529 Plan vs. Roth IRA

  529 Plan Roth IRA
Who Can Open One? Almost anyone Individuals with earned income
Contribution Limits No limits, but contributions above $16,000 in a year could trigger gift-tax liability $6,000, or $7,000 if 50 or older in 2022
Financial Aid Impact 5.64% maximum of account assets; withdrawals don’t count as income Assets aren’t counted; withdrawals count as income
Investment Options Varies by state; age-based and customized portfolios are available Whatever stocks, bonds, mutual funds, and ETFs you choose

Who Can Open One

Most adults can open a 529 plan for a beneficiary, including parents, grandparents, aunts, uncles, and family friends. You can also open a 529 plan and name yourself as the beneficiary to save for your own future education expenses.

The person who opens the account is the owner and makes the investment decisions. They can also change the beneficiary of the account to a family member of the original beneficiary.

A Roth IRA is an account you open for yourself individually, though you can also fund a Roth IRA for your spouse if you file a joint tax return. To contribute, you need taxable compensation. You also can’t earn more than the Roth IRA income limits. In 2022, single taxpayers earning more than $144,000 and married couples filing a joint return with an income above $214,000 are ineligible to contribute.

Contribution Limits

529 plans technically don’t have annual contribution limits, but if you contribute more than $16,000 in 2022 to any beneficiary other than yourself, you could be liable for federal gift taxes. You can also avoid potential gift taxes by “forward funding” an account with up to five years’ worth of contributions in a single year, bringing the maximum contribution to $80,000. States impose aggregate limits of anywhere from $235,000 to $529,000 on 529 plan balances.

The maximum Roth IRA contribution for 2022 is $6,000 if you’re younger than 50. People 50 and older can contribute up to $7,000 because they’re allowed an extra $1,000 catch-up contribution.

Financial Aid Impact

While a 529 plan can reduce a student’s need-based financial aid, the impact is relatively minimal. If a parent or dependent owns the 529 plan, the Federal Application for Federal Financial Aid (FAFSA) will calculate the assets at a maximum of 5.64% of the account’s value. In other words, the student’s aid award for a school year wouldn’t decrease by more than 5.64% of the 529 plan’s value. However, withdrawals aren’t treated as income.

Assets in a Roth IRA don’t affect financial aid, regardless of whether they’re owned by the parent or student. But withdrawals do count as income on the FAFSA—even if you limit your distributions to the amount of your contributions. Roth IRA withdrawals can have a substantial impact on the expected family contribution, counting at a rate of anywhere from 20% to 50%.

FAFSA has a two-year lookback period, meaning your financial aid award for the 2022-23 school year is based on 2020 tax returns. For this reason, it’s commonly recommended that you limit education-related Roth IRA withdrawals to the final two years of college.

Investment Options

Your 529 plan investment options will vary by state, but you’ll typically choose from a selection of mutual funds and exchange-traded funds (ETFs). Age-based portfolios, which start out primarily invested in stock funds and shift to more-conservative investments as the child gets older, are a common option. Some states let you choose investments based on the level of risk you’re willing to take.

You have greater flexibility with Roth IRA investments. You can invest in virtually any individual stocks and bonds, mutual funds, or ETFs you choose.

You can invest in a state’s 529 plan, even if you’re not a state resident.

The Bottom Line

Both 529 plans and Roth IRAs can be good tools for education savings. If you expect your child to receive financial aid, a 529 plan is the better option because withdrawals won’t affect your expected family contribution. But if you’re looking for the flexibility to use your money for either education or retirement, saving in a Roth IRA deserves consideration.

However, it’s important to consider how prepared you are for retirement before using your Roth IRA for your child’s education. If you don’t have access to a workplace retirement account or you’re behind on retirement savings, think carefully before dipping into Roth funds for education.

Frequently Asked Questions (FAQs)

What happens to a 529 plan if my child doesn’t attend college?

As the account owner, you could switch the beneficiary to another family member or even yourself. You could also withdraw the money for non-education purposes and pay taxes and a 10% penalty on the earnings.

What happens to 529 plan money if my child gets a scholarship?

You can use 529 funds to pay for expenses the scholarship doesn’t cover, such as room and board or textbooks. If you don’t use the money for education expenses, you’ll pay income taxes on the earnings part of the distribution, but you won’t owe a 10% fee.

Can you get a tax deduction on 529 plan or Roth IRA contributions?

Contributions to 529 plans and Roth IRAs are never deductible on your federal tax return. However, many states give you a tax break when you contribute to their 529 plan.

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