529 Plan vs. Roth IRA: How do the College Savings Options Measure Up?

by Prof. Robert Bloink and Prof. William H. Byrnes

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. 529 college savings plans and Roth IRAs 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 Section529education savingsplans 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 December 31 deadline—meaning that the funds must be received and deposited into the account by December 31, 2019 to qualify as a contribution for the 2019 tax year. In some states, the contribution need only be postmarked by December 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.

Selecting the Right Funding Option

Many clients may question why they would use a Roth IRA, which is primarily geared toward retirement savings, in order to fund their child’s education expenses. For clients who are eligible to contribute to a Roth based on the annual income limits, a motivating factor for choosing the Roth over the Section 529 plan could be the fact that Roth contributions are not counted against the annual or lifetime gift tax exclusion or exemption—while 529 contributions do count toward these limits.

Other clients might be more attracted to the Roth option if they have already maxed out 529 contributions based upon state limits and want to save more toward college. The Roth option can also be useful for clients who might want to use the funds for retirement expenses should the child not need the funds for educational expenses—for example, because the child has received a scholarship or an attractive financial aid package.

Despite this, Roth funds cannot be withdrawn within an initial five-year period without incurring unfavorable tax results. Further, for clients with no earned income for the year, the Roth contribution option is not available, but the 529 plan may still be a viable savings solution. The impact of using the Roth or 529 plan funds upon the student’s financial aid eligibility must also be evaluated in light of both types of accounts.

Conclusion

Ultimately, the decision to fund a Section 529 education savings account or a Roth IRA with a client’s limited funds may come down to personal preference, but clients interested in saving for a child or grandchild’s higher education expenses should be informed of both tax-preferred options before making the choice.