Roth IRA as College Savings Vehicle

Posted August 2020

When selecting a vehicle for college savings, most people naturally gravitate toward the Section 529 Plan (529 Plan). It offers some remarkable benefits and afterall, it is called a “college saving fund.” But before making this decision, it is a good idea to explore some of the alternatives, especially the Roth IRA.

Both the Roth IRA and 529 Plan are funded with nondeductible contributions and allow you to take qualified distributions of contributions and earnings tax-free. Some 529 Plans even offer state tax benefits. When it comes to college savings, the most significant advantages of 529 Plans are their generous contribution limits and their ability to accept contributions from relatives and friends. The contribution limits vary from plan to plan and from state to state, but many permit contributions of up to $400,000 or more. Annual contributions to a Roth IRA, which can only be made by the account owner, are currently limited to $6,000 per year. For those over 50 years of age, the contribution limit has increased to $7,000 per year. For example, if a 30-year-old couple with a newborn each contributes $6,000 per year to a Roth IRA, $12,000 total, they will have contributed $216,000 by the time the child reaches the age of 18.

Despite their lower contribution limits, however, Roth IRAs enjoy some significant advantages. Distributions from 529 Plans are only tax-free if you use them for “qualified higher education expenses,” including tuition and fees, room and board, books, and computers. These 529 Plans can also be utilized for certain elementary and secondary school expenses. If you use the funds for nonqualified purposes, the earnings portion of the distribution will be subject to taxes plus a 10% penalty. With a Roth IRA, on the other hand, you can generally withdraw contributions tax-free any time and for any purpose. That means you can use the funds for expenses that would not qualify for tax-free treatment under a 529 Plan. Examples include cars, other transportation expenses, and off-campus housing expenses over the college’s room and board allowance. Plus, once you reach age 59½ and the account is at least five years old, you can withdraw earnings tax-free as well and use them for any purpose.

Another advantage of the Roth IRA is that any funds you do not use for college expenses continue to grow indefinitely, providing you with additional tax-free retirement savings. Funds distributed from a 529 Plan that are not for qualified education expenses will be subject to taxes and penalties.

For more information or to discuss the relative pros and cons of 529 Plans, Roth IRAs, and other college savings tools, please contact us.