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

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 The funds can be withdrawn tax-free once the taxpayer reaches age 59.5. The direct after-tax contributions can be withdrawn tax-free at any time, but any earnings may generate tax liability (although the 10% penalty is waived if the funds are used to pay qualified education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.