When selecting a vehicle for college savings, most people naturally gravitate toward the Sec. 529 plan. And with good reason: It’s called a “college savings plan,” after all, and if offers some remarkable benefits. But before you make a decision, it’s a good idea to explore some of the alternatives, especially the Roth IRA.
Both Sec. 529 plans and Roth IRAs are funded with nondeductible contributions and both allow you to take qualified distributions of contributions and earnings tax-free. (Some Sec. 529 plans also offer state tax benefits.) When it comes to college savings, the biggest advantages of Sec. 529 plans are their generous contribution limits and their ability to accept contributions from grandparents and other family and friends. Limits vary from plan to plan and from state to state, but many permit total contributions of $400,000 or more. Annual contributions to a Roth IRA, which can only be made by the account owner, are currently limited to $6,000 per year ($7,000 if you’re 50 or older). In 2023, those limits increase to $6,500 and $7,500, respectively. So, for example, a 30-year-old couple with a newborn who contribute $13,000 ($6,500 each) per year to Roth IRAs will have contributed $234,000 by the time the child reaches age 18.
Despite their lower contribution limits, however, Roth IRAs enjoy some significant advantages. Distributions from Sec. 529 plans are tax-free only if you use them for “qualified higher education expenses,” including tuition and fees, room and board, books, and computers. (These plans can also be used for certain elementary and secondary school expenses.) If you use the funds for nonqualified purposes, the earnings portion of the distribution will be subject to taxes plus a 10% penalty. With a Roth IRA, on the other hand, you can generally withdraw contributions tax-free any time and for any purpose. That means you can use the funds for expenses that would not qualify for tax-free treatment if distributed from a Sec. 529 plan. Examples include cars or other transportation expenses and off-campus housing expenses in excess of the college’s room and board allowance. Plus, once you reach age 59½ (and the account is at least five years old), you can withdraw earnings tax-free as well and use them for any purpose.
Another advantage of the Roth IRA is that any funds you don’t use for college expenses continue to grow indefinitely, providing you with additional tax-free retirement savings. Sec. 529 funds that aren’t used for qualified education expenses will eventually be subject to taxes and penalties.
To discuss the relative pros and cons of Sec. 529 plans, Roth IRAs, and other college savings tools, please contact us.