Which is best: 529 college savings plan or Roth IRA?

Kathryn FlynnBy: Kathryn Flynn | 

The average cost of sending a child to a four-year public university is over $75,000 today, which means if you have a young child you can expect to pay over $150,000 when their time comes. If you have more than one child or choose a private school, your total college costs could easily end up totaling more than the price of your home.

So what’s the best way to save? This is America after all, so of course you have a variety of options. A mutual fund can have attractive growth potential, but you’ll likely end up paying a hefty tax bill. That’s why many people turn to tax-advantaged investment vehicles like Roth IRAs and 529 college savings plans.

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How the tax benefits work:

Roth IRA

In a Roth IRA, the principal portion (the amount you put in) can be withdrawn tax-free and penalty-free at any time for any purpose. Earnings in the account grow tax-free and can be withdrawn tax-free and penalty-free only after you reach retirement age. A key benefit of Roth IRAs is that distributions are not taxed as earnings until the entire principal balance is withdrawn. That means you can take out as much as you put in tax-free to pay for college and withdraw the earnings portion tax-free when you turn 59 1/2.

529 College Savings Plan

A 529 plan offers tax-free investment growth and tax-free withdrawals when the money is used to pay for qualified higher education expenses. If you take a non-qualified withdrawal, the earnings portion will be subject to income tax and a 10% penalty. Unlike a Roth IRA, every distribution contains an earnings portion and a contribution portion.

Residents in over 30 states can also claim an additional state tax credit or deduction for 529 plan contributions.

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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Earnings in a 529 plan are federal tax exempt when withdrawn for use on qualified higher education expenses.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.

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Income and contribution limits:

Roth IRA

In 2018, married couples filing jointly with a Modified Adjusted Gross Income (MAGI) less than $189,000 ($120,000 for individuals) can contribute the maximum amount of $5,500 to a Roth IRA. Couples with an MAGI of $199,000 or greater ($135,000 for individuals) are ineligible for a Roth IRA. If you are over 50 you may also be able to make a catch up contribution of $1,000 per individual.

529 College Savings Plan

Individuals of all income levels can enjoy the benefits of a 529 account. What’s more, there are generally no annual contribution limits and deposits up to $15,000 ($30,000 for married couples filing jointly) will qualify for the annual gift tax exclusion. If you’re looking to reduce your gift tax exposure through gifting, you can elect to make a contribution between $15,000 and $75,000 as made over five years. This is a common estate planning strategy for grandparents who want to ensure their legacy is being put to good use.

529 plans do have lifetime contribution limits that vary by state, ranging from $235,000 to over $500,000.

Effect on federal financial aid:

Roth IRA

Retirement accounts are not considered assets on the Free Application for Federal Student Aid (FAFSA), which means the value of your Roth IRA won’t hurt your chances for financial aid eligibility.

However, when you take out money from your Roth to pay for college it will be counted as untaxed income on the FAFSA. Income has a much greater impact on financial aid eligibility than assets.

529 College Savings Plan

The value of a 529 college savings plan, whether it is owned by a dependent student or one of their parents, is considered a parental asset on the FAFSA. When determining the EFC, only a maximum of 5.64 percent of a parent’s assets will be used to pay for college expenses. This is much lower than accounts that are considered the student’s assets, which are assessed at 20 percent. Lower EFC means more financial aid.

Withdrawals from parent- or student-owned 529 accounts are excluded from federal income tax return and do not have to be added back to base-year income on the following year’s FAFSA. Keep in mind that this favorable treatment does not apply to 529 plans owned by grandparents or other relatives.

ORIGINAL POST: 01/13/2015; UPDATED 7/11/2018

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.

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Kathryn Flynn

Kathryn Flynn

Content Director

Kathryn is Content Director at Savingforcollege.com. She has been quoted in financial publications including the Wall Street Journal, the NY Times, Fortune, Money and GOBankingRates, and has been an expert guest on personal finance podcasts. Prior to Savingforcollege.com, Kathryn worked in product marketing at Henderson Global Investors (now Janus Henderson Investors), a global asset manager. She earned her MBA with Finance Concentration from DePaul University's Kellstadt Graduate School of Business, and has prior FINRA Series 7 and 63 licenses. Kathryn has 529 college savings plans for each of her three children, and enjoys creating content to help other families prepare for future higher education costs.