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Robert Bloink and William H. Byrnes

Financial Planning > College Planning > Saving for College

Roth IRA vs. 529 Plan: How Should Your Clients Save for College?

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What You Need to Know

  • Section 529 plans and Roth IRAs are among the more popular options for those saving for their children’s college education.
  • Each option has a different set of rules and characteristics that clients should be made aware of.
  • Clients can choose to fund both types of savings vehicles, but the type of savings plan will depend on the client’s goals.

With summer in full swing, proactive clients with children may be even more focused on those children — and their futures. In 2023, the average cost of a four-year public college is well over $100,000 for in-state tuition. The average tuition for four-year private universities is over $223,000.

Understandably, clients with children may be interested in exploring every available tax-preferred college savings option. Fortunately, as with retirement savings vehicles, several tax-friendly savings options exist. Section 529 plans and Roth IRAs are among the most popular education savings options. Each type of plan has its own set of characteristics that clients should understand when allocating limited dollars for college savings.

Roth IRA vs. 529 Plan: The Basics

Roth IRAs are funded with after-tax dollars to generate tax-free income later in life, usually during retirement. The funds can be withdrawn tax-free once the taxpayer reaches age 59.5. The direct after-tax contributions can be withdrawn tax-free at any time, but any earnings may generate tax liability (although the 10% penalty is waived if the funds are used to pay qualified education expenses).

Similarly, Section 529 education savings plans are funded with after-tax dollars that are permitted to grow on a tax-free basis. 529 plan distributions are not taxed when received so long as they are used to pay for qualified higher education expenses (a 10% penalty on the earnings portion may apply if the funds are not used for qualified expenses).

Each savings plan has annual contribution limits. In 2023, the maximum that a client can contribute to a Roth IRA is $6,500 ($7,500 if the client is at least 50 years old). The contribution limit for 529 plans is based on the annual gift tax exclusion amount, so clients can contribute up to $17,000 in 2023 ($34,000 for married couples).

Clients also have the option of contributing five years’ worth of contributions to the Section 529 plan in a single year (up to $85,000 in 2023).

Unlike Roth accounts, 529 plans are regulated at the state level, meaning that options for funding these plans can vary significantly depending upon the state rules governing the plan. For example, the rules governing contribution deadlines vary by state. State laws also limit the amount that can be accumulated within the 529 plan over a lifetime (the aggregate limit varies from state to state and can be somewhere between $235,000 and $529,000).

Considerations When Selecting the Right Plan

Many clients may question why they would use a Roth IRA, which is primarily geared toward retirement savings, to fund their child’s education expenses. In the past, the primary pro-Roth argument was that it’s always possible that a child will not attend college (or will receive a scholarship) so that the 529 plan funds won’t be needed. Under the Setting Every Community Up for Retirement Enhancement (Secure) 2.0 Act, however, taxpayers will be permitted to roll up to $35,000 in Section 529 plan dollars into a Roth IRA beginning in 2024.

Taxpayers who earn more than $228,000 as a married couple or $153,000 as an individual cannot contribute directly to a Roth IRA. These taxpayers can execute Roth conversions to fund the account, but those conversions generate current tax liability.

For clients eligible to contribute directly to a Roth based on the annual income limits, the Roth may be more attractive than the Section 529 plan given that Roth contributions are not counted against the annual or lifetime gift tax exclusion or exemption — while 529 contributions are treated as gifts that count toward these limits.

Other clients might be more attracted to the Roth option if they have already maxed out their annual 529 contributions based upon state limits and want to save more toward college. The Roth option can also be useful for clients who might want to use the funds for retirement expenses should the child not need the funds for educational expenses — for example, because the child has received a scholarship or an attractive financial aid package.

Despite this, clients should remember that earnings on Roth contributions are taxable if they are withdrawn within five years of opening the account. Further, if the client has no earned income for the year, the Roth contribution option is not available, but the 529 plan may still be a viable savings solution.

Many states also offer a state income tax deduction or credit for contributions to Section 529 savings plans — while no states offer a similar deduction for Roth contributions.

The impact of using the Roth or 529 plan funds upon the student’s financial aid eligibility must also be evaluated. Roth accounts generally are not reported as assets for Free Application for Federal Student Aid purposes, while 529 plans can affect the child’s eligibility for need-based financial aid. On the other hand, the Roth distributions themselves are counted as income for FAFSA purposes.

Conclusion

Of course, many clients will choose to fund both Roth IRAs and Section 529 plans. Contributing to one type of plan does not affect the client’s ability to fund the other. In the end, the type of savings plan that fits will depend on the client’s goals and unique financial position.


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