529 Plans vs. Roth IRAs: Which Is Better for College Savings?

Roth IRAs are often mentioned an alternative to 529 savings plans as a way to save for college. Both invest after-tax savings, accumulate earnings on a tax-deferred basis and enjoy tax-free distributions if the distributions are used for qualified education expenses such as tuition, books and room and board at an eligible education institution.

But there are differences that parents and their advisors should consider when choosing one plan over the other to save for college, whose costs can run as high as $70,000 a year for a private, nonprofit institution if no financial aid is given.

Mark Kantrowitz, publisher and vice president of research at Savingforcollege.com, compared both types of saving vehicles and found that 529 plans are a better option if parents expect their child will enroll in a higher-ed institution. The comparable benefit is even greater if the family lives in a state that offers a state income tax deduction or credit on 529 plan contributions.

Currently, 34 states plus the District of Columbia allow tax deductions or tax credits on contributions, but the benefits vary. Deductions range from roughly a couple of thousand dollars to as high as $12,000 per married couple, but some states limit them to in-state 529 plans only. Parents need to learn the details and consider whether they live in a state with an income tax.

A Roth IRA is a better choice for parents only if they have serious doubts that their child will attend college and there’s no sibling or other relative who can become the new beneficiary of a 529 plan, says Kantrowitz.

The only other primary benefit of a Roth IRA over a 529 plan to finance college costs is the number of investment options. Roth IRAs usually have more options than 529 plans, but they’re not necessarily needed, according to Kantrowitz.

Keep in mind that contributions to Roth IRAs — used for any purpose — are limited to individuals with modified adjusted gross incomes under $135,000 and under $199,000 for couples filing taxes jointly, and contribution amounts begin to phase out starting at $120,000 for individuals and $189,000 for couples.

There are no income restrictions for donors to 529 plans, but there annual contribution limits of $15,000 for individuals and $30,000 for couples, which equal the annual gift tax exclusion for each. Alternatively, individuals can contribute up to $75,000 and couples $150,000 as a lump sum since 529 plans allow for five-year gift tax averaging. Contribution limits for Roth IRA plans are far lower: $5,500 for individuals and $6,500 if 50 or older (Roth IRA accounts are limited to individuals, so a couple can contribute $11,000 or $13,000 combined.)

Financial Aid

Another significant advantage of 529 plans over Roth IRAs for college savings is the impact on financial aid eligibility.

Balances of 529 plans owned by a dependent student or custodial parent are reported as assets on the Free Application for Federal Student Aid, which students must file to qualify for financial aid. The balances are assessed at a 5.64% rate, meaning if a 529 plan of a dependent student or custodial parent has $1,000 saved, $56.40 of that will apply toward the expected family contribution used to calculate financial aid eligibility.

Roth IRA assets are not reported as an asset on the FAFSA, so all distributions are counted as either taxable or untaxed income income for a student, and they are assessed at up to 50% when calculating the EFC.

This difference is most important for freshmen and sophomores during their first semester assuming graduation in four years. Since the FAFSA uses tax returns from two years prior, Roth IRA distributions after the first sophomore semester will not affect aid eligibility if the student graduates in four years.

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