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529 Plan vs. Roth IRA? The Roth Wins, Mostly

Thanks to its flexibility and investment choices, a Roth IRA account is a great college savings tool; but in some situations, a 529 savings plan is the better choice.
Sept. 17, 2018
College Savings, Financial Planning, Investing, Roth IRA
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You already know college is expensive, so it’s a good thing there’s not one but two tax-smart ways to save for those costs: Roth IRAs and 529 plans. So which is better for you?

To start, it’s worth noting that the rules for Roth IRAs and 529s are similar. (For this piece, we’re focusing on 529 savings plans, not prepaid tuition plans.) With either a Roth or a 529, you put money in after taxes, and your savings grow tax-free. As long as you follow the rules, you’ll never owe taxes on the investment earnings in either account.

As long as you follow the rules, you’ll never owe taxes on the investment earnings in either account.

For many savers, the Roth IRA is appealing because of its flexibility — these are retirement accounts, but you can always take out your contributions without penalty — and its wide array of low-cost investment choices.

Let’s break down the general virtues of the Roth, and the situations in which a 529 can beat it.

Roths are for retirement — but they’re flexible

Roth IRAs were created to encourage people to save for retirement. But, unlike with other retirement accounts, you can always withdraw the Roth IRA money you have contributed, any time, free of taxes and penalties.

Note the emphasis on “contributed” there. If you withdraw the investment earnings in your Roth account before age 59½, you’ll likely owe income taxes and a 10% penalty on the money you take out of the account.

There are some exceptions: If you take out Roth money to pay for qualified college costs, then you won’t owe the 10% penalty. You will, however, owe taxes on any investment earnings you withdraw (unless you’re over age 59½ and have owned the account for five years or more).

For most parents who are unsure about the costs of college, or how much they will contribute, it’s hard to beat the Roth.

Mark Struthers, founder of Sona Financial

“I like the Roth best because of the flexibility and wider investment choices,” says Mark Struthers, certified financial planner and founder of Sona Financial. “Once the Roth is maxed out, I love the 529 plan. But for most parents who are unsure about the costs of college, or how much they will contribute, it’s hard to beat the Roth.”

You open a Roth IRA account at a broker, ideally a low-cost broker. Here’s more on how and where to open an IRA.

529s are for college (and K-12, too)

With a 529 plan, as long as the money you withdraw goes to qualified education costs, you won’t owe taxes or penalties. And the “qualified” costs include up to $10,000 for elementary and high school tuition.

But if the money goes to some other purpose, you may owe taxes and a 10% penalty on investment earnings. That means that, unlike with a Roth, you can’t simply bank those earnings for retirement if your son or daughter decides to forgo college.

Still, there are some situations in which the scales may tip in favor of a 529:

  • If your state offers a 529 tax break and has a good 529 plan. That deduction or credit is like free money — and who turns down free money? (Well, actually, you might want to if your state’s 529 has terrible investment options with expense ratios north of 1%.) We’ve listed which states offer 529 tax breaks.
  • If you’re going to need financial aid. Roth withdrawals generally count as income in the Free Application for Federal Student Aid, or FAFSA, calculation, and having more income can put a bigger dent in how much aid your family gets. (Note that Roth IRA assets are ignored by FAFSA as long as the money is sitting in the account. It’s only the withdrawals that can cause financial aid pain.) Meanwhile, 529s are sort of the opposite: While distributions from a parent-owned 529 won’t hurt financial aid, parent-owned 529 assets can count against you on the FAFSA, though the percentage hit for assets is much less than for income. (The rules are different for 529s owned by relatives who aren’t the beneficiary’s parents.) This is a pretty big win in favor of 529 plans, though Struthers says one strategy is to time Roth distributions for “later in college when you won’t have to apply for aid the following year.” Note that the FAFSA now requires your income information from two years earlier; for example, on the 2018-19 FAFSA, you report 2016 tax return data.
  • If you’re above the Roth IRA limits. At higher incomes, you may encounter Roth IRA contribution limits. The 529 plan says pshaw to income limits!
  • If you’re late to the college-savings game and you want to stash a lot of money away every year. Roth IRAs have annual contribution limits ($5,500 a year, or $6,500 if you’re age 50+). There are no annual limits holding back 529s. (Though if you’re giving more than $15,000 to someone in a year, read up on the gift tax.)
  • If you’re certain one of your kids (or another relative) will use the 529 money for college, you won’t be 59½ when they go to college, and you’re not bothered by any possible investment constraints. In that case, you might as well take advantage of the 529’s lack of income taxes on earnings withdrawals. Remember, while paying for qualified education expenses gets you off the hook for the Roth’s 10% penalty, it doesn’t necessarily sidestep all income taxes on withdrawals.

“I usually recommend that parents take advantage of Roth accounts if they’re eligible,” says Brett Tushingham, a certified financial planner and managing member of Tushingham Wealth Strategies. “After they maximize their Roth contributions, we then explore 529 accounts, as they offer similar tax-free withdrawal benefits when used for qualified education expenses.”

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