The average cost of sending a child to a 4-year public university is over $75,000 today, which means if you have a young child, you can expect to pay over $150,000 when their time comes. If you have more than one child or choose a private school, your total college costs could easily total more than your home’s price. Fortunately, there are tax-advantaged accounts that can help families save for college.
Let’s compare two common ways to save for college: 529 vs Roth IRA. A Roth IRA is a type of Individual Retirement Account (IRA) that allows you to make after-tax contributions and then withdraw the funds tax-free in retirement. On the other hand, a 529 plan is a type of college savings plan that is sponsored by colleges, states, or their institutions and has a range of tax advantages.
Compare college savings options
Roth IRA vs 529 Plan: Key Differences
Roth IRA and 529 Savings Plans can both be excellent ways for families and individuals to save for college. However, there are certain key differences between the two:
- State income tax benefits: Over 30 states, as well as D.C., allow state income tax deductions or tax credits on contributions to 529 plans, while no states offer deductions or credits for Roth IRAs.
- Annual contribution limits: For 529 plans, annual contribution limits to avoid gift tax consequences are $18,000 or $36,000 for couples in 2024. The limit on Roth IRAs is lower, at $7,000 per year or $8,000 for those aged 50 or older.
- Earned income cap on contributions: 529 plans do not have an earned income cap on contributions, while Roth IRAs do.
- 5-Year gift tax averaging: Roth IRAs are not subject to 5-year gift tax averaging, while a $90,000 limit ($180,000 for couples) applies for 529 plans.
- Aggregate contribution limit: There are no aggregate contribution limits for Roth IRAs, while there are limits for 529 savings plans, which vary by state between $235,000 to more than $500,000.
- Third-party contributions: 529 plans allow third-party contributions, while Roth IRAs do not.
- Investment options: 529 saving plans have limited static and dynamic portfolios, while Roth IRAs offer a broader set of investment options, including stocks, bonds, mutual funds, and EFTs.
- Qualified distributions: Distributions from your 529 plan are tax-free if used to pay for qualified higher education expenses or K-12 tuition. Roth IRA accounts offer tax-free returns on contributions at any time, as well as all distributions held for five years if the account holder is aged 59 ½.
- Financial aid impact (assets): Roth IRAs are not reported as an asset on the FAFSA, while 529 plans are, and may reduce financial aid eligibility by 5.64% of the asset value if owned by a dependent student or a parent.
- Financial aid impact (income): 529 plan distributions may be counted as income if a parent or student does not own the account, but not if it is listed as an asset. All distributions from Roth IRAs, including a tax-free return on contributions, count as taxable or untaxed income on the FAFSA.
Let’s look at some of these key differences in more detail.
How the tax benefits work
Roth IRA
In a Roth IRA, the principal portion (the amount you put in) can be withdrawn tax-free and penalty-free at any time for any purpose. Earnings in the account grow tax-free and can be withdrawn tax-free and penalty-free only after you reach retirement age. A key benefit of Roth IRAs is that distributions are not taxed as earnings until the entire principal balance is withdrawn. That means you can take out as much as you put in tax-free to pay for college and withdraw the earnings portion tax-free when you turn 59 1/2.
If you withdraw earnings from your Roth IRA account before you reach retirement age, you will be subject to income tax and a 10% penalty on the earnings.
There is an exception to the early withdrawal penalty if the funds are used to pay for qualified higher education expenses. However, you will owe income taxes on the earnings portion of the early distribution.
529 college savings plan
A 529 plan offers tax-deferred investment growth and tax-free withdrawals when the money is used to pay for qualified education expenses.
Qualified education expenses for 529 plans include:
- College costs such as tuition, fees, and room and board
- Up to $10,000 per year in K12 tuition
- $10,000 in student loan repayments
If you take a non-qualified 529 plan withdrawal, the earnings portion will be subject to income tax and a 10% penalty. Unlike a Roth IRA, every distribution contains an earnings portion and a contribution portion.
Residents in over 30 states can also claim an additional state tax credit or deduction for 529 plan contributions.
Income and contribution limits
Roth IRA
In 2024, married couples filing jointly with a Modified Adjusted Gross Income (MAGI) less than $230,000 ($146,000 for individuals) can contribute the maximum amount of $7,000 to a Roth IRA. Couples with a MAGI of $240,000 or greater ($161,000 for individuals) are ineligible for a Roth IRA. If you are over 50, you may also be able to make a catch-up contribution of $1,000 per individual.
529 college savings plan
Individuals of all income levels can enjoy the benefits of a 529 account. Moreover, there are generally no annual contribution limits, and deposits up to $18,000 ($36,000 for married couples filing jointly) will qualify for the annual gift tax exclusion in 2024. If you’re looking to reduce your gift tax exposure through gifting, you can elect to spread a contribution between $18,000 and $90,000 over five years. This is a common estate planning strategy for grandparents who want to ensure their legacy is being put to good use.
529 plans have lifetime aggregate contribution limits varying by state, ranging from $235,000 to over $500,000.
Sources of contributions
Roth IRA
Third parties cannot contribute to a taxpayer’s Roth IRA. However, some parents and grandparents give the student a gift up to their earned income, which the student then contributes to the student’s Roth IRA.
529 college savings plan
All friends and family can contribute to a student’s 529 plan, regardless of who the 529 plan’s account owner is.
Effect on federal financial aid
Roth IRA
Retirement accounts are not considered assets on the Free Application for Federal Student Aid (FAFSA), which means the value of your Roth IRA won’t hurt your chances for financial aid eligibility.
A Roth IRA distribution, however, may be reported as income on the FAFSA. If you take a taxable distribution, the taxable income is added to your adjustable gross income (AGI). Qualified distributions are reported as untaxed income.
529 college savings plan
The value of a 529 college savings plan, whether it is owned by a dependent student or one of their parents, is considered a parental asset on the FAFSA. When determining the Student Aid Index (SAI), only a maximum of 5.64 percent of a parent’s assets will be used to pay for college expenses. This is much lower than accounts that are considered the student’s assets, which are assessed at 20 percent. Lower SAI means more financial aid.
Withdrawals from parent- or student-owned 529 accounts are excluded from federal income tax returns and do not have to be added back to base-year income on the following year’s FAFSA. Keep in mind that this favorable treatment also now applies to 529 plans owned by grandparents or other relatives.
Summary: 529 vs Roth IRA
529 Plan | Roth IRA | |
Tax Benefits | Tax-deferred growth and tax-free distributions for qualified education expenses | Return of contributions is tax-free, funds can be completely withdrawn tax-free at retirement |
Income Limits | None | Less than $240,000 (married) Less than $161,00 (single) |
Annual Contribution Limits | None, though contributions count towards annual gift tax exclusion ($18,000 in 2024) | $7,000 ($8,000 for age 50 and older) |
Effect on Financial Aid | 5.64% of parent-owned accounts are counted as an asset | Distributions may be reported as income |
Factors to Consider when Choosing a 529 or Roth IRA
There is no clear-cut choice when it comes to educational IRA vs 529. The right type of plan will depend on a number of factors, most notably:
- Do you want to be limited to paying for college with your money? Funds from 529 plans can only be withdrawn penalty-free if you use them to pay for qualified expenses related to your college education. Therefore, it’s important to think about whether you’re sure your child will attend college or if you want to be free to use the funds for something else.
- How could you take advantage of the tax benefits? Roth education IRA plans offer competitive tax advantages. While 529 plans have their own tax advantages, it’s important to closely compare these to see which will benefit your situation most.
How will it impact your eligibility for financial aid? Both 529 plans and Roth IRA for college savings may be counted on the FAFSA, which could have a minor impact on your child’s financial aid eligibility.
Is a Roth IRA better than a 529 plan?
A 529 savings plan is generally an all-around good choice to pay for your child’s (or your own) college, while a Roth IRA may be a better option as a backup account to supplement educational expenses.
The ideal would be to contribute to both a Roth IRA and a 529 savings plan – this will give you the maximum flexibility to pay for your child’s college in the most effective way and save for your retirement. If you’re worried about having unspent funds in a 529 account, there’s good news on the horizon. Starting in 2024, you may be able to do a tax-free rollover of funds from a 529 plan to a Roth IRA within certain limits.
