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So Says the 529 Guru
Wednesday, June 2nd 2004
Question: Am I better off saving for college with a Roth IRA or a 529 plan? What are the advantages and disadvantages of each?
Answer: The best approach, as you might guess, would be to do both. Of course, that may not be possible depending on how much you can afford to save each year, and it also assumes you meet certain eligibility requirements attached to the Roth IRA*. With limited cash flow, you may have to make choices, and for most people, the Roth IRA takes precedence over the 529 plan.
While both types of savings vehicles can be used effectively for college, the Roth IRA is clearly superior for retirement. And isn't saving for retirement a more critical need than saving for college? After all, you and your child can borrow for college if necessary. Borrowing for retirement is a more difficult proposition.
The unique beauty of the Roth IRA is in the tax ordering of distributions: contributions come out before earnings. Since the contributions were not deducted on your tax return, they can be withdrawn free from any tax or penalty. This gives you the ability to tap your Roth IRA at any time and for any purpose (including college) without worrying about tax consequences, as long as you do not dip into the earnings.
Earnings withdrawn from your Roth IRA are excluded from income once you reach 59 ½ and satisfy a five-year test (limited exclusions also exist in cases of death, disability, and the first-time purchase of a home). A distribution of earnings prior to age 59 ½ will be subject to tax at your ordinary income rate and will incur a 10% early distribution penalty. IRA proceeds used for the qualified higher-education expenses of yourself, your spouse, your children or your grandchildren avoids the 10% penalty, but not the income tax.
Here's an example of how a Roth IRA can be tapped for college without creating a tax liability:
At age 40, John begins contributing $3,000 per year into his Roth IRA. The account grows at an annual rate of 8%. At the end of five years, with his daughter Emily in college, John has $19,008 in his Roth IRA, consisting of $15,000 in contributions and $4,008 in earnings. John withdraws $15,000 to pay for Emily's college tuition. The entire $15,000 distribution is a tax-free return of contributions. John leaves the $4,008 of earnings in his Roth IRA to continue growing until he reach age 59 ½ at which time he may withdraw it without tax or penalty.
If John had the same investment experience using a 529 savings plan instead of a Roth IRA, the $15,000 distribution would be pro-rated between contributions ($11,837) and earnings ($3,163). Although the entire amount will qualify as a tax-free distribution**, the earnings of $845 remaining in the 529 account could eventually be subject to tax and 10% penalty if distributed in a year after Emily leaves college.
IRAs may have other advantages over 529 plans. They offer greater investment flexibility by permitting self-direction of investments, which is not allowed in 529 plans. They are also offered at a lower cost than many 529 savings plans that impose an extra layer of program fees.
Are there any situations in which a 529 plan is a better college investment than a Roth IRA? Certainly. In the example above, John could have withdrawn the entire $19,008 on a tax-advantaged basis from the 529 plan for Emily's college expenses, not just $15,000. 529 plans offer other advantages. You may be eligible for a state income-tax deduction, matching contribution, or other benefit with your 529 contribution that you do not get with a Roth IRA. This incentive may be enough to warrant a diversion of your annual savings from a Roth IRA to the 529 plan. You may also find that 529 plans offering special types of investments, including age-based options, guaranteed investment contracts, and tuition prepayment contracts, better satisfy your college savings objectives.
And consider the potential impact on your student's financial aid eligibility. Under current federal guidelines, the 529 savings account is assessed as an asset of the account owner, which is generally considered good news. But the balance in a Roth IRA is not picked up at all in calculating the expected family contribution to college costs. Although this sounds like a tremendous advantage for the Roth IRA, the picture can change dramatically if the Roth IRA is actually withdrawn for college expenses. All withdrawals (principal and earnings) are picked up as base-year income on the following year's financial aid application, and base-year income is assessed at rates as high as 50% in the financial aid calculation. (If you plan on using your Roth IRA to meet college expenses, consider borrowing the money instead and repaying the debt with IRA withdrawals after your child finishes his or her junior year.) Contrast this treatment with a 529 plan: If withdrawals are excluded from income tax they are also excluded from base-year income for financial aid.
Here's the bottom line: reserve your Roth IRA for its best use, which is retirement. For college, take a look at 529 plans and perhaps Coverdell ESAs. If you are not comfortable figuring it out on your own, I suggest you seek the assistance of a financial professional who specializes in college planning. You may locate such a professional on our Find a 529 Pro Directory at or NICCP.
*You must have compensation or alimony income of at least the amount of your Roth IRA contribution, and to make the maximum contribution of $3,000 in 2004 ($3,500 if you are 50 or older) your modified adjusted gross income must be below $95,000 ($150,000 if you are married filing jointly). The contribution limit is phased out for incomes between $95,000 and $110,000 (between $150,000 and $160,000 if you are married filing jointly).
**The income tax exclusion for qualified withdrawals from a 529 plan is currently scheduled to expire at the end of 2010. Unless Congress acts to extend or make permanent the exclusion, the earnings portion of qualified withdrawals after 2010 will be reported to the account beneficiary.