Comparison of 529 plans and Roth IRA for college savings

Mark KantrowitzBy Mark KantrowitzBy Savingforcollege.com

Comparison of 529 plans and Roth IRA for college savings

Mark KantrowitzBy Mark KantrowitzBy Savingforcollege.com

Both 529 college savings plans and Roth IRAs can be used to save for college. However, a 529 plan offers several advantages when the student enrolls in college and a Roth IRA is better when the student decides to not go to college.

A 529 plan is a tax-advantaged way of saving for college that minimizes the impact on eligibility for need-based financial aid. A Roth IRA gives the student a head start on saving for retirement if the student does not use the money to pay for college, but can hurt the student’s aid eligibility.

Similarities between 529 plans and Roth IRAs

529 plans and Roth IRAs are similar in that contributors invest after-tax dollars in both savings plans. Earnings accumulate on a tax-deferred basis and qualified distributions are entirely tax-free.

The earnings portion of a non-qualified distribution is taxed as ordinary income and may be subject to a 10% tax penalty. The 10% tax penalty on a non-qualified distribution from a Roth IRA is waived if the distribution was made to pay higher education expenses. The 10% tax penalty on a non-qualified distribution from a 529 plan is waived when the beneficiary receives a scholarship, veterans’ educational assistance, employer-provided educational assistance, the American Opportunity Tax Credit, the Lifetime Learning Tax Credit and other forms of educational assistance. Both 529 plans and Roth IRAs waive the tax penalty upon the death or total and permanent disability of the beneficiary.

Find your 529 plan - Select your state below

Did you know that residents are not limited to investing in their own state's plan? Another state may offer a plan that performs better and has lower fees. Select your state below to see your state's plan and other options.

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Find a 529 Plan. Select your state below.

Did you know that residents are not limited to investing in their own state’s plan? Another state may offer a plan that performs better and has lower fees. Select your state below to see your state’s plan and other options.


Contributions to a 529 plan or Roth IRA

There are several differences concerning contribution limits and income phase-outs between 529 plans and Roth IRAs.

Annual contribution limits

  • The annual contribution limit on a Roth IRA is $5,500 ($6,500 if age 50 or older) or your earned income, whichever is less.
  • Contributions to a 529 college savings plan can be up to the $15,000 annual gift tax exclusion ($30,000 for a couple making a joint contribution) without incurring gift taxes or using up the lifetime gift tax exclusion. 529 plans provide 5-year gift tax averaging for contributions above the annual gift tax exclusion amounts, up to five times the annual gift tax exclusion, or $75,000 ($150,000 for a couple making a joint contribution).
  • Contributions to a 529 plan do not depend on earned income.

Aggregate contribution limits

  • Aggregate contribution limits for a 529 plan vary by state. The aggregate contribution limits usually depend on the highest projected cost of seven years of college costs for colleges in the state, ranging from $235,000 to $529,000 in 2019.
  • There is no aggregate contribution limit on a Roth IRA.

Income phase-outs

  • Contributions to a Roth IRA are phased out for income of $189,000 to $199,000 (married filing jointly) or $120,000 to $135,000 (single).
  • There are no income phase-outs on 529 college savings plans.

Sources of contributions

  • Third parties cannot contribute to a taxpayer’s Roth IRA. However, some parents and grandparents give the student a gift up to their earned income, which the student then contributes to the student’s Roth IRA.
  • All friends and family can contribute to a student’s 529 plan, regardless of who is the 529 plan’s account owner.

Investment options for 529 plans and Roth IRAs

529 college savings plans offer a limited number of investment choices. Typically, a 529 plan provides several mutual funds with static and dynamic asset allocations.

  • The static investment options include mutual funds that differ according to the percentage equities, as well as broad-based bond funds and low-risk investments.
  • The dynamic asset allocations include age-based asset allocations that reduce exposure to equities and other high-risk investments as college approaches. These are similar to target date funds.

A Roth IRA can be invested in a broader set of investments, including stocks, bonds, mutual funds and exchange-traded funds (ETFs).

Get smart about taxes

What is the tax benefit of a 529?

Earnings in a 529 plan are federal tax exempt when withdrawn for use on qualified higher education expenses. This is what your federal tax savings could be if you save for 18 years.

See the best 529 plans of 2019

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$25$500
Monthly Contribution

Impact of a 529 plan and Roth IRA on taxes

About three dozen states and the District of Columbia offer a state income tax deduction or state income tax credit on contributions to the state’s 529 plan. Roth IRAs do not benefit from state income tax deductions or tax credits.

Investors in a Roth IRA can take a tax-free return of contributions at any time. On the other hand, earnings are included proportionally in all distributions from a 529 plan.

A distribution of earnings from a Roth IRA is considered to be qualified if the Roth IRA has been held for five or more years and the taxpayer is greater than age 59 and a half at the time of the distribution. There are exceptions for distributions due to death, disability or a qualified first-time home purchase.

Qualified distributions from a 529 plan do not depend on the age of the beneficiary or account owner.


Impact of a 529 plan and Roth IRA on financial aid

529 plans are treated more favorably than Roth IRAs by college financial aid formulas.

Treatment as assets

  • 529 plans that are owned by a dependent student or the dependent student’s parent (custodial parent if the parents are divorced or separated) are reported as a parent asset on the Free Application for Federal Student Aid (FAFSA).
  • 529 plans that are owned by anybody else, such as a grandparent, aunt or uncle, are not reported as an asset on the FAFSA.
  • Parent assets on the FAFSA reduce eligibility for need-based financial aid by at most 5.64% of the asset value.
  • The Roth IRA is not reported as an asset on the FAFSA.

Treatment as income

  • Distributions from a 529 plan are ignored on the FAFSA if the 529 plan is reported as an asset on the FAFSA. Otherwise, distributions count as untaxed income to the beneficiary.
  • Untaxed income on the FAFSA reduces aid eligibility by as much as half of the distribution amount.
  • Qualified distributions from a Roth IRA and a tax-free return of contributions from a Roth IRA count as untaxed income to the beneficiary on a subsequent year’s FAFSA.
  • Non-qualified distributions from a 529 plan or Roth IRA will count as part of adjusted gross income.

Workarounds

  • If the student will graduate in four years, distributions that occur on or after January 1 of the sophomore year in college will not affect eligibility for need-based financial aid, since the FAFSA is now on a prior-prior year (PPY) system that is based on two-year-old income and tax information.
  • If the student will graduate in five years, distributions must occur on or after January 1 of the junior year in college to have no impact on aid eligibility.
  • Another workaround is to wait until after the student graduates from college to take a tax-free return of contributions from the Roth IRA to pay down student debt.

Comparison of 529 plans and Roth IRAs

This chart summarizes the differences between 529 plans and Roth IRAs, with a focus on the impact on taxes and financial aid.

Features

529 Plans

Roth IRAs

Enacted

1996

1997

State Income Tax Deduction or Tax Credit on Contributions

34 states + DC

No

Annual Contribution Limit

$15,000 ($30,000 as couple)

$5,500 ($6,500 if age 50+)

Earned Income Cap on Contributions

No

Yes

5-Year Gift Tax Averaging

Yes. $75,000 ($150,000 as couple)

No

Aggregate Contribution Limit

$235,000 to $529,000 (varies by state)

None

Income Phase-out on Contributions

None

$189,000 to $199,000 (MFJ)

$120,000 to $135,000 (S)

Allows Contributions by Third Parties

Yes

No

Investment Options

Limited set of static and dynamic portfolios.

Broader set of investment options, including stocks, bonds, mutual funds, and ETFs

Qualified Distributions

Tax-free if used to pay for qualified higher education expenses or K-12 tuition.

Tax-free if age 59-1/2 and held for five years. Tax-free return of contributions at any time.

Non-Qualified Distributions

Earnings portion of distribution is subject to ordinary income taxes plus a 10% tax penalty.

Earnings portion of distribution is subject to ordinary income taxes plus a 10% tax penalty.

Tax Penalty Waived

The tax penalty is waived up to the amount of a scholarship or other educational assistance received by the student.

The tax penalty is waived if the non-qualified distribution pays for educational expenses.

Financial Aid Impact (Assets)

Aid eligibility reduced by up to 5.64% of asset value if account is owned by a dependent student or the student’s custodial parent. If account is owned by anybody else, including a grandparent, aunt or uncle, it is not reported as an asset on the FAFSA.

Not reported as an asset on the FAFSA.

Financial Aid Impact (Income)

If the account is not reported as an asset on the FAFSA, qualified distributions count as income to the student, reducing aid by up to half of the distribution amount. Non-qualified distributions are reported in the student’s income.

All distributions, including a tax-free return of contributions, count as taxable or untaxed income on the FAFSA. This reduces eligibility for need-based financial aid by up to half of the distribution amount.

Impact of Prior-Prior Year

Distributions that occur on or after January 1 of the sophomore year in college will not affect aid eligibility if the student graduates in four years.

Distributions that occur on or after January 1 of the sophomore year in college will not affect aid eligibility if the student graduates in four years.


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