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Roth IRAs vs. 529s: A College-Savings Smackdown

Using a retirement account to save for college invites many potential pitfalls. 

Adam Zoll, 05/14/2013

Question: Rather than use a 529 college-savings plan to provide for college expenses in the future, I plan to use a Roth IRA and invest the money in a target-date fund based on when my child will enter college. Any problems with this plan?

Answer: Using a Roth IRA to save for college can be an intriguing idea. One reason is that Roth IRA contributions can be withdrawn tax-free for any purpose. And while you'll typically face taxes and a 10% early-withdrawal penalty if you take out investment earnings from your Roth before age 59 1/2, the 10% penalty usually assessed for early withdrawals from an IRA is waived if funds are used to pay for college tuition, books, fees, and other qualified expenses.

Advantages of Using a Roth
Like a 529, a Roth IRA allows for tax-free growth of money invested in the account, and distributions are tax-free, assuming one meets certain requirements. In the case of tax-free 529 withdrawals, the requirement is that you use the money for qualified college expenses; in the case of Roth IRAs, you must be age 59 1/2 to withdraw your whole balance (contributions plus investment earnings) without taxes or penalties.

One clear advantage of using a Roth IRA to save for college is that the variety of investment options is far broader. Rather than being limited to funds available in a given 529 plan, a Roth IRA account holder can choose whatever mutual funds he or she likes, along with using individual stocks, bonds, certificates of deposit, and other investments. Traditional mutual funds also tend to have lower fees than those available in 529 plans, as discussed in this video. And the fact that Roth IRA contributions can be withdrawn at any time without taxes or penalties means they can be used for other purposes--for example, in an emergency. Contrarily, 529 funds that are not used for college-related expenses may incur taxes plus a penalty.

In most cases, parents would likely consider using their own Roth IRAs to help pay for college. But some parents might consider opening a Roth IRA for their child with the expectation that any funds not used for college remain in the account to give the child a head start on saving for retirement. The only caveat to this strategy is that each year the beneficiary must have earned income at least equal to the amount contributed to the IRA. So a child who only works a low-paying summer job, for example, may not make enough to invest the maximum $5,500 per year allowable for a Roth (or traditional) IRA.

Why a 529 Often Is a Better Choice
So now that you know how you can use a Roth IRA to save for college, should you do it? Before answering, consider some of the disadvantages to this strategy:

Diverts retirement resources: If you are depending on the Roth IRA to help fund your retirement you may be depriving yourself of years of tax-free growth and distributions by removing funds from the account to pay for college. By draining tens of thousands of dollars from a Roth you are giving up potentially even larger amounts, held in a tax-free account, when you retire. Remember: Your child can get loans to help pay for college, but no one will loan you money to live on during your golden years. Also, for many people without Roth 401(k) options, the Roth IRA is their sole chance to get retirement assets into the tax-free withdrawal column, and from that standpoint it's very valuable.

Lower contribution limits: Annual contributions to a Roth IRA are limited to $5,500, or $6,500 if the account holder is 50 or older. With a 529, contributions are limited only by the gift tax exclusion, which currently is $14,000 per year for gifts from one individual to another (individuals who don't think they'll ever be subject to the gift tax could potentially contribute even more). That means a married couple could contribute up to $28,000 per year with no gift tax consequences. And for 529s there's an accelerated gifting provision that allows an individual to use up to five years' worth of the exclusion in a single year as long as no more is given in the subsequent four years. That means a parent could contribute up to $70,000 to a child's 529 in a single year (or $140,000 if coming from a couple). Read more about this strategy in this article. For higher-income college savers thinking of sending their child to a pricey private school, or who simply want to maximize their tax-advantaged college savings, this higher limit is a clear point in favor of 529s.

Adam Zoll is an assistant site editor with Morningstar.com

 

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