Dear Joe, I am an undergrad considering opening a 529 or a Roth IRA to help fund graduate school. Which would be more beneficial in terms of guaranteeing more financial aid? -- Clayton
The Roth IRA is probably the better choice for you, not necessarily because of its financial aid treatment, but because of its flexibility. Here are some of the major considerations when comparing it to a 529 plan.
Retirement accounts are not considered assets on the Free Application for Federal Student Aid, or FAFSA, thus giving a Roth IRA a potential edge over a 529 plan. For an independent graduate student, a 529 account owned by you will reduce your aid eligibility by 20 percent of the account's value. However, if you file Form 1040A or 1040EZ and have an adjusted gross income below $50,000, you may qualify for the "simplified EFC formula" -- a method of calculating a student's financial need and a family's contribution -- and none of your assets, including 529 plans, will be counted.
For income-tax purposes, a Roth IRA and a 529 plan have some similarities. Contributions are not deductible on your federal tax return and distributions of principal are always tax- and penalty-free. Generally, the earnings in a Roth IRA can be withdrawn without tax or penalty only after reaching age 59½, while the earnings in a 529 account can be withdrawn without tax or penalty only in the year the account beneficiary incurs qualified higher education expenses.
There is one major difference. Roth IRA distributions aren't taxed as earnings until the principal has been fully withdrawn. With 529s, the plan administrator breaks out the distribution between principal and earnings, based on IRS rules. Of those two elements, the principal is not taxable; the earnings are, unless the distribution is qualified as payment of college costs.
Roth IRA principal comes out before earnings, while 529 withdrawals are prorated between principal and earnings. This rule makes the Roth IRA more flexible. You can withdraw Roth principal for any purpose, including education, and retain the earnings in the account for future tax-free distribution in retirement.
For financial-aid purposes, the key to using a Roth IRA is to wait until your final year of school before taking withdrawals to pay higher-education expenses or to repay student loans taken in earlier years. If you were to take IRA withdrawals for your first year of graduate school, those withdrawals must be included as student income when applying for your second year of school. Since income hurts your aid eligibility, you'll want to avoid that situation.
In fact, you may ultimately decide to keep your Roth IRA intact and not use it at all for school. If you can land a high-paying job after graduating, you may find yourself able to handle student loan repayments out of your current budget and keep your Roth IRA fully invested for your future retirement.
If you live in a state that provides you with a state income tax deduction or credit for your contributions to a 529 plan, the tax savings may be sufficient to swing your decision in favor of the 529 plan, especially if it makes no difference in determining financial aid eligibility.