Should you use a Roth IRA or a 529 plan for your child’s college expenses? You can choose the 529 plan or go with a Roth IRA and invest in a target-date fund based on when you expect your child to enter college.
To help you weigh your options, take a look at the pros and cons of both, so you can make an informed decision based on your child’s needs.
Advantages of a Roth IRA
- A Roth IRA allows for tax-free growth of your money.
- Distributions are tax-free, assuming one meets specific requirements.
- A Roth IRA account holder can choose from a number of mutual funds, along with using individual stocks, bonds, certificates of deposit, and other investments.
- Traditional mutual funds tend to have lower fees than those available in 529 plans. This is due to the management and administration fees associated with 529 plans.
- Roth IRA contributions can be withdrawn at any time without taxes or penalties.
- Some parents choose to open a Roth IRA for their child with the expectation that any funds not used for college can remain in the account to give the child a head start on saving for retirement.
- In the event that your child does not go to college, your invested funds can be shifted towards your retirement.
Advantages of a 529
- More than 30 states offer a tax deduction or tax credit for committing to a 529 plan.
- Annual contributions have high limits (in most cases, individuals can contribute in the six figures).
- People of all income levels are eligible to contribute to a 529 plan.
- College savings plans are open to residents of any state.
- Withdrawals that are used to pay the beneficiary’s qualified education expenses are completely income tax-free at the federal level.
- Once every 12 months you can roll over the beneficiary’s 529 account to a different 529 plan for the same beneficiary without tax or penalty implications. This qualifies you to choose various investment opportunities if your current plan is not meeting your required rate of return.
- Plan contributions qualify for the annual gift tax exclusion. All money contributed to the plan incur no tax or filing requirement.
Disadvantages of a Roth IRA
- Most fund companies require minimum initial payments of at least $2,500 a year.
- Contributions must be included in base-year income, which can hinder financial aid benefits.
- If you have more than a couple of children, the Roth IRA might not give you enough leeway to contribute towards your retirement and save enough for your kids. High fund requirements may reduce your ability to contribute for multiple children, leaving you with a decision between retirement and your children’s college savings.
- Funds that reside in a Roth IRA cannot be used as collateral for a loan, per current IRS rules, and therefore cannot be used for financial leveraging or for investment purposes.
Disadvantages of a 529
- 529 plans charge various fees to cover investment expenses and the administration of your account.
- Early withdrawals from a 529 plan that are not used for the beneficiary’s qualified education expenses are taxed and penalized.
- College savings plans don’t guarantee your return and are subject to risk; you could lose some or all of the money you’ve contributed.
- Prepaid tuition plans generally require that all tuition credits be used before the beneficiary reaches age 30, and all withdrawals are completed within 10 years of the time the beneficiary starts college.
- College savings plans aren’t legally required to let you change the investment option on your existing contributions once per calendar year or allow you to choose a new investment option for any future contributions.
- You are generally limited to the prepaid tuition plan offered by your state of residence.