529 beats Roth IRA for college savings

04/14/2008

QUESTION:
Dear Joe,

Can my son use a Roth IRA -- rather than a cost-laden 529 -- to fund his 9-month-old daughter's future education?

-- Jim

ANSWER:
Dear Jim,
To contribute to a Roth IRA, you must have earned income more than or equal to the amount of the contribution. Dividends and interest income don't count as earned income. Many children do have jobs and can start a Roth IRA, but I've never heard of a 9-month-old joining the workforce -- except, perhaps, for those actors in baby commercials.

Even if a child does qualify for a Roth IRA, I think it makes for a much better retirement vehicle than it does a college-savings vehicle. Earnings on a Roth can be distributed tax-free after the account owner reaches age 59½ and satisfies a five-year requirement. But earnings that come out before age 59½ are taxable even when used for college expenses. (The 10-percent early distribution penalty may be waived under the special exception for higher-education expenses.)

Of course, one nice part about a Roth IRA is that your contributions come out before the earnings do. In addition, the contributions portion can be used for any purpose, including education, without tax or penalty.

The surprise for many parents, however, is the potential financial-aid penalty: The entire IRA distribution, taxable or not, must be included in base-year income on the student's federal financial-aid application for the following year. This can dramatically reduce a need-based aid package.

In my opinion, your son should take another look at a 529 plan for his daughter. Contrary to popular belief, 529s are not necessarily laden with a lot of costs. In fact, the expenses associated with 529 plans have dropped significantly over the past few years.

Savingforcollege.com, recently published its annual 529 fee study comparing costs between all of the "direct-sold" 529 plans.

The study underscores how low costs are for many 529 plans. For example, in the Ohio CollegeAdvantage 529 plan, a $10,000 investment in the least-expensive equity investment option will cost only $293 over 10 years. That figure includes the expenses of the underlying Vanguard mutual funds.

With a 529 plan, the distributions used to pay qualified higher education expenses are tax-free regardless of your age, and they are not included in base-year income for federal financial-aid purposes.

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