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

Note: This article is part of Morningstar's October 2013 College-Savings Boot Camp special report. This article originally appeared May 14. 

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 One reason is that Roth IRA contributions can be withdrawn tax-free for any purpose.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 And the fact that Roth IRA contributions can be withdrawn at any time without taxes or penalties means they can be used for other purposes--for example, in an emergency.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.

No state income tax deduction: More than 30 states offer a tax deduction or tax credit for contributing to a 529 plan (usually this only applies to contributions to in-state plans). Contributions to a Roth IRA are not deductible on your state or federal tax return.

Glide paths may not suit college savers: You mentioned the idea of funding a Roth IRA with a target-date fund that has the target year set for when your child will enter college. This would basically mimic how the age-based portfolios available in many 529 plans work. Both target-date funds and age-based 529s slowly tilt their allocations away from equities and toward safer investment classes as the target event approaches, but one is not a substitute for the other. That's because the rate at which this rebalancing occurs--referred to as the glide path--differs greatly between age-based 529s and target-date funds.

In the case of a 529 the target event--starting college--usually has a very definite time frame and a short duration. It's likely that the student will need the money in a specific year and that it will need to last for three years (or four or five) after that. But retirement is often far less predictable. Many people who plan to work until age 65 find themselves retiring earlier because of health problems, or working longer because they haven't saved enough or simply because they enjoy it. Most significantly, a 529's glide path is designed for a four-year (or so) drawdown period. Because target-date funds often are used for retirement accounts, their glide paths are designed for a drawdown period that lasts for decades. As a result, 529 glide paths often feature much lower allocations to equities at the time the account is tapped than target-date funds do.

The chart below illustrates this difference. It shows the average 529 age-adjusted portfolio's glide path and the average glide path for "to" and "through" target-date funds. "To" target-date glide paths provide a changing allocation only up to the date of retirement, whereas "through" target-date glide paths continue changing the allocation well into retirement. The average 529 glide path currently has an allocation to equities of just 14% at its target event--when the beneficiary reaches age 18 and is most likely to start college. For the typical target-date fund, the allocation to equities is much higher at the target event. The average "to" target-date fund's glide path has an equity allocation of 35% at that point while the average "through" target-date glide path is 48%. Again, this is because the money in a target-date fund usually has to last through decades of retirement but also because new retirees have more time to ride out market volatility.

Using a target-date fund to save for college means that you risk being overallocated to equities just when the money is needed, with little time to recover should a major market sell-off occur. As a result, managing a college-savings portfolio inside a Roth IRA requires a far more hands-on approach compared with using an age-based 529 account, which wins points for its ease of use.

Financial aid implications: One final problem with using a Roth IRA to help pay for college involves financial aid. Although retirement accounts are not counted as assets in need-based financial aid calculations, distributions from them--even if taken from Roth contributions only--are counted as income the year after they are taken. (This is true whether the Roth is held in the parent's name or the student's.) So unless taking a distribution during the student's final year in school, when financial aid the following year is no longer an issue, this strategy could hurt financial aid eligibility. Assets in 529 plans also count against financial aid; however, they are counted as assets, which have a lower impact on financial aid than income does. 

Saving for college through a Roth IRA might make sense in some cases. But generally you're best off using the account for what it is intended for--saving for retirement. Should you need the money to help pay for college expenses at some point, it's nice to know it's available. But as a primary college-savings vehicle, it clearly has its drawbacks.

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