With tax time behind us, many clients must now turn their focus toward their savings goals for the year ahead. While the importance of saving for retirement cannot be overstated, the reality is that many clients are simultaneously juggling saving for a variety of different goals—and saving for a child’s education may be a top priority for many clients.
As with retirement savings, several different savings options exist for these clients, each with its own benefits and risks that the client must evaluate to decide which vehicle best suits their family’s needs. Roth IRAs and 529 college savings plans are two primary modes of saving on a tax-preferred basis—and while both share many similar traits, clients should understand the details of each type of account before choosing their preferred college saving mechanism.
529 Plans vs. Roth Accounts: Benefits and Limits
Roth IRAs are funded with after-tax dollars to generate tax-free income later in life, usually during retirement. Similarly, IRC Section 529 education savings plans are funded with after-tax dollars that are permitted to grow on a tax-free basis (and function much like a Roth IRA), so that distributions from the account are not taxed when received so long as they are used to pay for qualified higher education expenses. Nonqualified 529 plan distributions—those not used to pay for qualified education expenses—are included in gross income, but only to the extent that the distribution represents earnings on amounts that were contributed. In other words, the after-tax funds that were originally contributed would not be taxed a second time upon distribution.
For most clients, Section 529 plans will permit a higher tax-free contribution level ($15,000 per year gift-tax-free) than the Roth option (which carries a $6,000 limit, unless the client has established a Roth 401(k) to save for college expenses, in which case the client can contribute $19,000, or $25,000 if the client has reached age 50). Clients also have the option of contributing five years’ worth of contributions to the Section 529 plan—up to $75,000—in a single year.
Unlike Roth accounts, 529 plans are regulated at the state level, meaning that options for funding these plans can vary significantly depending upon the state rules governing the plan. For example, the rules governing contribution deadlines vary by state. Some states impose a strict Dec. 31 deadline—meaning that the funds must be received and deposited into the account by Dec. 31, 2019, to qualify as a contribution for the 2019 tax year. In some states, the contribution need only be postmarked by Dec. 31, 2019, to qualify as a 2019 contribution. Other states model their deadline after the IRA contribution rules, and may allow contributions to count for 2019 if they are deposited by the April 15, 2020, tax filing deadline.