Roth IRA vs. 529 Plan for College Funding
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Most parents want to provide the best educational opportunities to their children. It is quite disheartening if they fail to do so due to lack of funds. Thus, one of the most important reasons for parents to save is to fund their children’s college education. College funding can be a confusing task with numerous financial instruments to choose from. However, there are specifically two such options that are considered highly feasible; a Roth individual retirement account (IRA) and a 529 plan. It is imperative to view both these alternatives across various dimensions comparatively. The following assessment can be useful in understanding the advantages and disadvantages of both:
Table of Contents
1. Flexibility
This is an essential factor of contemplation before selecting either of the two opportunities. A Roth IRA allows investors to utilize their money to fund all their important needs. Children’s higher education can still be financed by other means, but retirement is one avenue that has to be taken care of by individuals themselves. A Roth IRA gives freedom of investment without deciding on the purpose. The investors can choose to use the money either for themselves, their children’s education, or both. This account offers higher flexibility to the investors because, in the case of 529 plans, the funds can only be utilized for the listed educational expenditures. While there are certain exemptions like scholarships, the investors will have to pay taxes and penalties if the money is used to fund any other requirements. Certain contributions that receive state income tax benefits will also have to be returned. Thus, if the children choose not to attend the qualified schools or pick the ones with lower-than-expected expenditure, then the parents will have to bear the burden of taxes/penalties.
2. Income Restrictions
A Roth IRA faces several restrictions in terms of earnings. Those in higher-income categories are not allowed to invest in it. For a single taxpayer or a married taxpayer, who is filing income tax separately, the income threshold is $139,000. For joint filing by couples or widows/widowers, the income limit is $206,000. However, in the case of 529 plans, there are no such income restrictions.
3. Contribution Limitation
Contribution to a Roth IRA by a single taxpayer or a married taxpayer who is filing income tax separately can be $6,000, if they are earning $124,000. Lesser contributions can be made by those with income between $124,000 and $139,000. Contribution by couples filing jointly or widows/widowers can be $6,000 if they are earning up to $196,000.
Smaller contributions can be made by those with income between $196,000 and $206,000. If the taxpayer is over the age of 50, the contribution can go up to $7,000. In the case of 529 accounts, there are no such limitations. An annual contribution of up to $15,000 or $30,000 in the case of joint filing is exempted from annual gift tax. Alternatively, you can make a contribution of up to $75,000 equivalent to a five-year worth of contributions in a single year.
5. Contribution Restrictions
For a Roth IRA, the contribution must be made by the individual who has earned the income during the accounting year. This implies that only the primary beneficiary is permitted to contribute to the account. No such contribution restrictions are levied on 529 accounts.
5. Investment Restrictions: Roth IRAs do not involve any form of federal or state restrictions for investment. However, in the case of 529 plans, investment policies across various states are different. Some states follow conventional investment policies, and this can interfere with the goals of many investors. This is because the main purpose of investing in a savings plan is to earn good returns. With conservative investment guidelines, this purpose gets defeated.
6. Tax Advantages
Under a Roth IRA, it is permissible to withdraw the original investment amount at any point to fund any of the investors’ requirements without any tax or penalty. The returns or earnings from the investment can also be drawn out without any burden of tax or penalty, if the withdrawal is made after the investor attains the retirement age of 59.5. This implies that funds can be withdrawn from Roth IRAs for educational expenses without having to pay taxes or penalties.
Furthermore, no tax is levied on the distributions as long as the investors do not draw out the complete amount of original principal investment. However, the tax and penalty policies associated with 529 accounts are different. When the funds in 529 accounts are utilized towards the payment of qualified educational purposes, the investors will not have to pay any tax or penalty on withdrawals. Also, the returns on the funds invested in these plans do not come under any tax liability. It must also be noted that in 529 accounts, each distribution is divided into two parts; one is a contribution and the other earnings.
Moreover, an extra state tax credit or deduction is offered to the investors for 529 accounts across more than 30 states. If an investor decides to withdraw money for any purpose other than the qualified higher educational expenditure, they will have to pay income tax, along with a penalty of 10%.
7. Government Financial Support
This is a very significant point of consideration. The Free Application for Federal Student Aid (FAFSA) does not consider the funds invested in Roth IRAs as part of the investors’ asset portfolio. This, in turn, implies that any investment in these accounts will not adversely affect the investors’ eligibility criteria for receiving government financial support. However, it must be noted that when the funds from a Roth IRA are used for acceptable educational expenses, those funds are assumed to be untaxed income by the FAFSA. This income can have an impact on the student’s eligibility to receive financial aid for education.
On the other hand, the FAFSA includes the investment in 529 college accounts in the asset value of the parents. This account value is included irrespective of the ownership status of the account. So, the account could be owned either by the parents or the student. In addition to this, up to 5.64% of the total value of the parents’ asset portfolio is permitted towards the funding of college expenditures at the time of the calculation of expected family contribution (EFC). Conversely, in the case of the assets of the student, this proportion increases to 20%, resulting in a decline in EFC. This way, the student will be eligible for higher financial support from the government. But, there is no need to file a federal income tax return for the funds taken out of a 529 plan, owned either by the parents or the student.
To sum it up
The decision to invest in a Roth IRA or a 529 college savings account is extremely important as it can affect the rest of your life and alter the course of your child’s career. Several factors work in favor of both these savings plans. For each individual, the correct path forward will be different, depending upon various characteristic financial aggregations. To arrive at the best option, it will be necessary to undertake a comprehensive assessment of the factors mentioned above, alongside other determinants.
If you are struggling to choose between the two methods, appointing an experienced and knowledgeable financial advisor can help.
