Sunday, May 27, 2012

Roth IRA vs. 529 plan - Which is Better for College Savings?

Roth IRA
Roth IRA (Photo credit: Philip Taylor PT)

In USA Today they had a story that compared Roth IRAs to 529 Plans.  It said when it comes to saving for a child’s college education, a Roth IRA might be a better investment than a 529 Plan. I agree the column is right in suggesting that anybody who is thinking about saving for a child’s college expenses should consider a Roth IRA instead of, or in addition to, a 529 Plan.

The 529 Plan

A 529 Plan allows contributions to grow tax-free and distributions to be made without any taxes or penalty, if the distributions are for qualifying educational expenses.  So if you take $5,000 today, put it away in a 529 Plan for your child’s college, and it grows to $10,000 in 10 years, you can use that $10,000 for college and not owe any tax on your $5,000 in growth. But what if you need the money, or your kid decides not to go to college?  Well if you end up taking a withdrawal from the 529 Plan for something other than qualifying educational expenses, the earnings become taxable, and there’s a 10% penalty assessed on the earnings portion of a withdrawal.  

Benefits of the Roth IRA

Roth IRAs are designed for retirement savings, but are flexible because of the withdrawal rules.  At any time after the Roth IRA is established, an individual can withdraw contributions that were made to the Roth IRA for any reason without any penalty.  If an individual has had a Roth IRA for at least five years, contributions and earnings can be withdrawn without any penalty and without any taxes if the distribution is a qualified distribution (examples of qualified distributions include distributions after the individual has reached age 59 1/2, or a withdrawal to help the Roth IRA owner or a qualifying family member buy a first home for the individual or a family member).

Where they Differ

Distributions from a Roth IRA to pay for qualifying educational expenses aren’t treated quite the same as qualifying distributions, since the earnings portion of the distribution is subject to tax. This is a key difference between the Roth IRA and the 529 Plan, where earnings distributed for qualified educational expenses aren’t subject to income tax.

Which is Best?

Roth IRAs easily have 529 Plans beat if you want flexibility. 529 Plans are state-sponsored programs and come with limited investment options which typically include mutual funds, CDs, and bonds.  With Roth IRAs, investors can actively manage the account and have a much broader array of investment options.

In addition to earnings being subject to income tax when distributed for educational purposes, Roth IRAs have a few other shortcomings as compared to 529 Plans.  529 Plans allow for significantly greater annual contributions. Roth contributions are capped at $5,000 for individuals under 50, or $6,000 for individuals 50 and over. 

If you are considering setting up or continuing to fund a 529 Plan for a child, you should consider contacting a financial planner to discuss whether a Roth IRA might be a better option for you.  Not only can a financial planner help you determine whether a Roth IRA is appropriate, but he or she can also help you navigate the rules regarding contributions and withdrawals.

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