One of the main questions that has come out of my 529 savings guide by age post is whether to contribute to a Roth IRA or a 529 plan to pay for college. This is a great question I did not think about because contributing to a Roth IRA is not something I have ever done due to maximum income limitations.
Fortunately or unfortunately, by the time I worked a full year in finance, I was no longer eligible to contribute to a Roth IRA due to the income limit requirement. Instead, I just focused on maxing out my 401(k) every year for the next 13 years until I left full-time work for good.
Partly due to my inability to contribute to a Roth IRA, I developed a negative bias towards the investment vehicle. It made no sense to me why the government would set arbitrary income limits for retirement savings. I believed everybody deserved to save efficiently for their future. Further, the article is a nice counterpoint to the 99% positive Roth IRA articles out there.
Now that I'm older, wiser, and have two children to consider, let's take a look at the pros and cons of contributing to a 529 plan or a Roth IRA for college. I'll also share some thoughts on which route is best for you.
Positives Of A 529 Plan For College
A 529 plan is a dedicated college and grade school savings plan that offers special tax advantages when used for education. Here are the main positives of contributing to a 529 plan.
1) Tax Advantages
The main positive of the 529 plan is that the money contributed to the plan can grow tax-free like the Roth IRA.
When money is withdrawn, the account holder does not have to pay any taxes if the money is used for qualified education expenses.
Qualified education expenses typically include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible education institution. Room and board can potentially be included as well for full-time students.
Starting in 2018, up to $10,000 per year from the 529 plan can be used for K-12 education expenses such as private school tuition and tutoring.
One of my regrets is not contributing to a Roth IRA when I was working at McDonald's or during my first year working in finance. If I had, I probably would have over $200,000 in my Roth IRA today.
2) State Income Tax Deduction
So far, over 30 states and the District of Columbia offer a state income tax deduction if you contribute to a 529 plan. The income tax deduction ranges from $1,000 to $10,000.
Unfortunately, California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota, New Jersey, North Carolina, and Tennessee have state income taxes and do not offer a state income tax deduction or tax credit for contributions to the state's 529 college savings plan.
Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming do not have state income taxes, therefore, they do not offer 529 plan contribution state income tax deductions.
3) Generous Contribution Limits
The 529 plan contribution limits are quite generous. The limits should be enough to cover the average cost of a 4-year public or private university tuition.
Every state's 529 plan allows for maximum contributions of at least $235,000 per beneficiary. Georgia and Mississippi have the lowest maximum balance limits at $235,000, followed by North Dakota at $269,000.
Idaho, Louisiana, Michigan, South Carolina, Washington state, and Washington DC have maximum limits of $500,000. While on the absolute highest end, Pennsylvania's limit is $511,758, New York's limit is $520,000 and California's limit is $529,000 for 2021. These limits will adjust over time due to inflation.
To reach a $500,000 contribution limit over 18 years requires an average contribution of $27,777 a year. Therefore, I think we can agree that these contribution limits are quite high, especially once you factor in potential returns.
These contribution limits apply to each beneficiary. For example, in California, which has a $529,000 maximum contribution limit, a set of parents contributing $500,000 for a beneficiary and a set of grandparents also contributing $500,000 to the same beneficiary would not be allowed.
4) Easy To Change Beneficiaries
If your child turns out to be a gifted athlete like Michael Jordan (The Last Dance documentary is amazing) or a genius like Albert Einstein, he or she might get a full-ride, rendering your 529 plan contributions unnecessary. Your child might also decide not to go to college, which is becoming a wiser and wiser choice in this digital age.
In either case, you can easily change the 529 beneficiary to someone else in your family tree. Qualified family includes the beneficiary's siblings, parents, children, first cousins, nieces and nephews, among others.
An example of a lateral change. You have established 529 savings accounts for your son Bob and daughter Nancy. Bob gets a full scholarship for football with room and board paid as well. You can shift Bob's 529 funds to Nancy's 529 plan. If there is money left over from Nancy's plan, you can shift the remaining balance to your nephew.
An example of an upwards change. When your son Michael graduates from college, $100,000 is left in the 529 plan. You can transfer the $100,000 upward to your name to use towards a Masters degree in online marketing.
Just be aware that some states have restrictions on account ownership changes. Check with your own state before transferring just to be sure.
5) Reasonable Flexibility
If you are lucky enough to have a child get college grants/scholarships, you can withdraw up to the amount of that grant/scholarship penalty-free. You’ll still have to pay taxes on the earnings (any investment gains from your original contributions). But that just means you’ll have gotten tax-deferred growth in the meantime.
6) A 529 Plan Is A Wealth Transfer Tool
If you accumulate too much money in your 529 plan, you can always use it as a generational wealth transfer tool. In fact, if your estate is going to surpass the death tax threshold limit, opening up multiple 529 plans to fund your future generations is a fantastic tax-efficient idea.
7) You can roll over leftover 529 funds into a Roth IRA starting in 2024
Due to the passage of the SECURE 2.0 Act, you can now rollover leftover 529 funds into a Roth IRA starting in 2024. The rollover limit per year is the same as the Roth IRA contribution limit, $6,500. And you can only roll over a maximum $35,000 into a Roth IRA for now. Further, your 529 plan needs to be open for at least 15 years.
Here are more details about rolling over leftover 529 funds into a Roth IRA. The post also discusses who benefits the most from the new rollover benefit.
Negatives Of A 529 Plan For College
Here are three negatives of a 529 plan.
1) Penalties and Taxes
If you don't use the 529 plan money for qualified education expenses, then you'll pay a 10% penalty on your gains. You'll also be subject to income taxes on the gains and may even have to pay back any state income tax deductions you previously claimed.
If you received a state income tax deduction for your contributions, you may have to pay that contribution back as well.
Thankfully, only the earnings will be taxed and penalized. Your contributions are safe no matter what you do.
2) Opportunity Cost
Whatever you contribute to your 529 plan is money not contributed or spent elsewhere. Imagine living like a pauper for 18 years because you wanted to contribute $27,777 a year to your daughter's 529 plan and she turns out hating you, hating school, and not wanting to go to college? What a bummer!
Now imagine she was an only child. With no younger sister, you might have to look for someone you don't even really know in your family tree to transfer the funds.
This type of situation happens all the time. It's important to carefully assess your child's personality, intellectual ability, and belief about college while contributing to his 529 plan. Don't be a robot.
3) Limited Investment Options
Just like the 401(k), your investment options are limited to the plan you choose. Hopefully, you will choose a plan that has low-fee investment options. Target-date funds are popular in 529 plans, but they may carry higher fees.
If you go the actively managed fund route, hopefully the portfolio manager or team of analysts will at least perform in-line if not better than its benchmark index. Unfortunately, most active fund managers underperform their respective indices.
Positives Of A Roth IRA For College
Like the 529 plan, a Roth IRA holder contributes after-tax money. The money then gets to compound tax-free. If money is withdrawn after age 59.5, 100% of the withdrawal is tax-free.
You can withdraw up to the amount you've contributed without taxes or penalties at any time and for any reason. For example, if you contributed $100,000 to your Roth IRA and it has grown to $250,000, you can withdraw $100,000 any time without consequence.
You can also withdraw the earnings penalty-free, but not tax-free if the Roth IRA money is used for college expenses for you, your spouse, your children, or your grandchildren.
1) More Flexibility With A Roth IRA
The number one reason why you would want to save in a Roth IRA over a 529 plan is the flexibility. Nobody knows the future with certainty. For example, maybe in 10-20 years all college tuition will be free. I bet there's a 30% chance of this happening. Saving too much in a 529 plan would end up being a suboptimal financial decision.
It is generally better to put on your seat belt first and save for your retirement, and then save for your child's education. You don't want to end up old, broke, and unable to provide for your children. Eventually, you will want to stop working so hard and saving so much.
With a Roth IRA, you have more flexibility with how you want to use the funds. If your retirement is on track, especially if you've been maxing out your 401(k) and saving in a taxable brokerage account, then you can direct the money to your child’s education.
In addition to using your Roth IRA for college tuition, you can also use a Roth IRA for a house down payment. Every parent should consider encouraging their child to work and set up their own Roth IRA.
The other type of flexibility you have with a Roth IRA is the flexibility to invest in many more types of investments. Over the long run, investing in a low-cost index ETF will likely save you a bunch of money.
2) A Roth IRA Isn't Counted For Financial Aid Purposes
A final positive about saving in a Roth IRA for college is that it doesn't count when you apply for financial aid. Neither are your other retirement accounts such as the 401(k) or traditional IRA.
If you're rich enough to send your kid to college, but not rich enough to not feel the pain of paying for tuition, then having a Roth IRA may be better than a 529 plan. So many folks fall in this in-between category. The middle class really is getting squeezed.
When colleges analyze your family's finances, it will count a portion of your 529 plan amount to determine how much aid you may receive. If your child has an $800,000 529 plan, chances are slim-to-none he or she will get any free financial aid.
Despite the benefit of the Roth IRA not being considered in financial aid calculations, I hope none of you will intentionally adopt a poverty mindset that depends on others for financial help. Adopt an abundance mindset so you don't have to depend on anybody for aid.
Besides, only 5.64% of your savings is counted on the FAFSA. While supposedly up to 50% of your income is counted. Hence, if you want to game the college financial aid system, have less income and more of your assets in tax-advantaged retirement accounts.
Negatives Of A Roth IRA For College
Here are the biggest negatives of a Roth IRA.
1) Not Everybody Can Contribute
For 2023, the modified adjusted gross income for singles must be under $153,000 to be eligible to contribute to a Roth IRA. There are phaseout contribution amounts at various income levels.
Once you're over $153,000 for singles and $228,000 for married couples, you can no longer contribute to a Roth IRA. These income limits tend to go up by 1-2% a year to account for inflation.
If you end up getting a job in an expensive city such as San Francisco or New York City, you could easily earn over $140,000 within the first three years of employment. Cities are expensive because incomes are high.
It makes no sense to deny someone the ability to contribute to a Roth IRA just because they ended up working in a high-cost of living city.
2) The Maximum Contribution Limit Is Low
You can only contribute a maximum of $6,500 to a Roth IRA in 2023 if you are under 50. If you are over 50, you can contribute $7,500 to a Roth IRA for 2023.
This is up from $5,500 in 2019. $6,500 is better than a poke in the eye, but it's going to take many years and a decent compound growth rate to build a large enough portfolio to pay for college and retirement.
I've also written up different ways to pay for college beyond a Roth IRA or 529 plan as well. One of the ways is actually paying from your income while your kids are attending college. I never though of this as a retiree since 2012. Blind spot!
3) Withdrawals Count As Income
When you withdraw from your Roth IRA to pay for college, the withdrawal counts as income. Given income is the largest determinant in the financial aid process, you may eliminate any possibility of free aid.
For example, let's say your family makes $75,000 a year in household income. This level of income for even one child often qualifies a family for free financial aid. In fact, some private schools will pay 100% of tuition if a family earns less than $100,000 a year.
But if you withdraw $35,000 from your Roth IRA, you suddenly make $110,000 for the year and could be disqualified for free tuition.
Below is a list of the top colleges that provide 100% need-based scholarships. We're talking free tuition to most households who earn less than $100,000 – $150,000 a year.
- Amherst College
- Bowdoin College
- Brown University
- Colby College
- Columbia University
- Davidson College
- Harvard University
- Northwestern University
- Pomona College
- Princeton University
- Stanford University
- Swarthmore College
- University of Chicago
- University of Pennsylvania
- US Air Force Academy
- US Military Academy (West Point)
- US Naval Academy
- Vanderbilt University
- Washington and Lee University
- Yale University
Financial Aid Examples From Various Colleges
Below are more financial aid examples from various colleges that provide loan-free aid.
Strategically, if you find yourself at the income borderline for getting free money, wait until your child’s last year of college to withdraw money from a Roth IRA.
This strategy may help you get more aid at the expense of paying for the initial years with non-529 plan money. However, you may negatively affect a younger child from getting free aid. Do the math.
4) Puts Your Retirement At Risk
Any Roth IRA money used for college is not being used for retirement. Earlier Roth IRA withdrawals rob the money's ability to compound over time. On the flip side, if you withdraw the money right before a bear market, then you're actually saving money.
529 Plan Or Roth IRA To Pay For College?
The ideal scenario is if you can max out your 401(k), max out your Roth IRA, and contribute $15,000 a year in your child's 529 plan. Your goal should be to utilize each tax-advantageous account for its respective intended purposes.
If you can only choose to build a 529 plan or a Roth IRA to pay for college, here's what you should consider:
Focus on building a Roth IRA to pay for college if:
- You don't have children yet, but plan to
- You are behind in your retirement savings
- You are not sure if your kids will attend college
- Your kids have the potential to get free tuition due to academics, athletics, or other talents
- You don't want to work until you're 60+
- You believe college will become cheaper over time or free
- You are eligible, as many people are not
- You plan to make more in retirement than while working
Focus on building a 529 plan to pay for college if:
- You are already contributing to a Roth IRA and other retirement plans
- You are confident your kids will go to college and/private grade school
- You are happy with your occupation and plan to work for a very long time since you won't have a Roth IRA to help you in retirement
- You make more than the Roth IRA contribution income limits
- You have two or more children to whom you can transfer beneficiaries just in case the full 529 plan amount is not used
At the end of the day, if your child has earned income, opening a custodial Roth IRA is a no-brainer. The maximum amount contributed to a Roth IRA ($6,000 for 2021) will be tax-free since it below the standard deduction limit. The money gets to compound tax-free each year. After five years, it can then be withdrawn tax-free as well.
Recommendation To Plan For College
Better plan for college by sign up for Empower, the web’s #1 free wealth management tool to get a better handle on your finances. In addition to better money oversight, run your investments through their award-winning Investment Checkup tool to see exactly how much you are paying in fees.
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Recommendation To Diversify Your Investments For College
Investing in stocks and bonds to pay for college is fine. However, I suggest also investing in real estate to pay for college. Real estate is a more stable assets that provides utility and generates cash flow. Most of the wealthiest people in the world own real estate.
If you can't or don't want to buy a rental property, then invest in private real estate for the long run. My favorite private real estate investment platform is Fundrise. Fundrise invests primarily in single-family and multi-family homes in the Sunbelt, where valuations are cheaper and net rental yields are higher.
I've invested $810,000 in private real estate to earn more passive income and diversify away from my expensive San Francisco real estate holdings. Investing in real estate is a great way to benefit from inflation and positive demographic trends.
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