Using 529 Plans and Roth IRAs to Invest For College

ManyEducation Costs parents are now aware of the benefits of using a 529 plan when saving for college and are aware of the education expense exemption in an IRA. As college savings vehicles, 529 plans and Roth IRAs both have their advantages and disadvantages but provide some of the same main benefits. Both can provide tax free growth, and tax and penalty free distributions to pay higher education costs. However, there are important differences, and it is your own specific financial circumstances that help determine which is better for you.

Generally, distributions taken from an IRA before age 59 ½ are subject to a 10% penalty, however, there is an exemption for distributions used to pay qualified higher education expenses. The education expense exemption, combined with the tax-free properties of a Roth IRA, give the Roth IRA the ability to provide tax free growth and tax and penalty free distributions, if those assets are used to pay qualified higher education costs. The education expenses can be for the IRA owner or the IRA owner’s spouse, children or grandchildren. Qualified higher education expenses include tuition, fees, books, supplies and equipment, as well as room and board, if the student is enrolled at least half time in a degree program. 

Higher income earners will be phased out of the allowable Roth IRA contribution limits, making a 529 plan a better option during accumulation years. 529 plans also have higher annual contribution limits, and many states allow for state tax deductions or credits for contributions made to the state’s 529 plan. Roth IRAs provide no income tax deductions.

Financial aid eligibility is affected by certain parental assets, student assets, and your expected family contribution, and 529 plans and retirement assets are treated differently in this calculation. The values of a parent’s retirement assets (retirement plans, IRAs) are not considered as assets available to pay for college. This is an advantage of the Roth IRA, because a large Roth has no impact on financial aid calculations. Distributions from those retirement accounts are considered income, however, and increase your expected family contribution. This may lower the amount of financial aid the student will be eligible for. On the other hand, assets in 529 plans owned by a parent or the dependent student are treated as parental assets. There is an asset protection allowance of roughly the first $20,000 of parental assets. Up to 5.64% of those assets in excess of the asset protection allowance are considered available to pay for college. Distributions used to pay qualified education expenses are not included as income in the calculation.

Parent or student owned 529 plans get favorable treatment compared to other student owned assets, which are assessed at 20%. Distributions from 529 plans owned by grandparents are considered student income and are assessed at a much higher rate than 529 plans owned by parents or the student. If grandparents own the 529 plan, distributions reduce eligible financial aid by an amount equal to 50% of those distributions. The value of a 529 plan owned by a grandparent, however, is not included in the calculation.

One other distinction is that 529 plans now allow for tax free distributions when paying for costs associated with grades K-12 as well as for higher education costs. The education expense exemption in an IRA only applies to higher education costs.

The primary purpose of a 529 plan is to provide tax free growth and tax-free distributions for qualified higher education expenses. If distributions are not used to pay qualified education costs, taxes and penalties will be incurred. The Roth IRAs primary purpose is as a tax free retirement account, and is more flexible than a 529 plan.

529 plans and Roth IRA’s can both be good ways to pay for college. Your own specific situation will determine which is a better choice and the financial planning process is a great way to evaluate these options. Many of the issues that need to be considered are thoroughly addressed in the financial planning process. Taxes, income, cash flow, retirement planning and net worth all need to be considered when planning for college funding , but with a little planning, you can benefit from tax free growth, and tax and penalty free distributions from either a 529 plan, a Roth IRA or both, to pay future college costs.

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