Saving for College: 529 vs IRA

Recently I saw a recommendation that you should put your college savings into a Roth IRA instead of a College 529 plan because the Roth savings would not be included in parental assets for assessing whether your child would be eligible for financial aid. This, however, is not as straight forward as it might seem. There are trade offs that mean the real answer is it depends, and in these cases, I like to do the math.

First the rules. With both a 529 plan and a Roth IRA, your investment earnings grow tax-free while in the account. With the 529 plan, withdrawals for qualified educational expenses are tax-free as well. With the Roth, you can withdraw contributions tax-free, but the earnings will be taxed at your regular income tax rate. Roth withdrawals for educational purposes do not incur the 10 percent penalty for early withdrawal.

The 529 plans in thirty seven states allow you to deduct your contributions from your state income taxes up to a limit. In Oregon, for example, you can deduct $2,435 if you are single and $4,865 if you are married. However, you are limited to the investment options available in your state’s plan. If you don’t like those, or your state does not offer a 529, you can save for college in any other state’s plan, but you won’t get the tax deduction. Earnings still grow tax-free and are not taxed on withdrawal for education.

The argument in favor of using a Roth IRA is that retirement savings are not counted in your assets on the Free Application for Federal Student Aid (FAFSA). Therefore, in theory, your child would be eligible for more financial aid if you saved in a Roth instead of a 529 plan. However, the earnings on your savings will be taxed and you won’t get the state tax deduction for your contributions (if it’s available to you), so you will have less total savings available for college given the same annual savings amount.

Now for the math. Given the tax implications of saving in a Roth, are you really better off than if you saved in a 529 plan? The answer depends on how much savings you have outside of retirement plans. Your expected family contribution (EFC) based on your savings alone (there is also an income test) will be 5.64% of your family assets per year. Your home, retirement savings and an allowance for emergency savings are excluded from the calculation. The allowance for emergency savings is based on the average cost of living for a family of your size. It usually ranges between $25,000 and $35,000.

The following table shows how the two options compare when your child is about to enter college, assuming you save $2,400 per year from the time your child is born until they are eighteen. It also assumes you have $100,000 in savings outside retirement plans at that time. I’ve assumed federal and state taxes combined are 30 percent, and that 529 contributions get a state tax deduction of 9 percent, based on Oregon’s tax rate. College savings also earn 4 percent per year in investment returns.

529 PlanRoth IRA
Taxable Savings100,000100,000
College Savings After Taxes$64,825$54,691
Family Exclusion$30,000$30,000
EFC per Year$7,604$3,948
Additional Potential Financial Aid$3,656
Additional College Savings$10,135

In this example, for the same annual savings rate, you would be better off saving for college in the 529 plan. Between the tax exempt withdrawal and the tax deduction for contributions, which I’ve added to college savings, you would have nearly $6,500 more available for college (the difference between the additional college savings and the additional financial aid) than if you saved in a Roth IRA. The 529 advantage declines with more in taxable savings. Given my assumptions, the break even level of taxable savings is $215,000.

There is one other reason you might consider using a Roth IRA as a college savings vehicle. If your child does not go to college, the Roth IRA can stay invested, and you can use it for your own retirement, with withdrawals being completely tax-free after age 59 1/2. With the 529 option, if the funds are not used for education purposes, the earnings will be taxed at your income tax rate plus a 10 percent penalty. However, you can transfer the savings to another child, or use them for your own continued education tax-free. A variety of vocational classes as well as college classes are eligible educational expenses.

If the funds are not used for education, you will have $2,200 more savings in your Roth IRA, than if you withdrew the 529 plan money and paid the taxes when your child is eighteen. The Roth would continue to grow tax-free until retirement. Alternatively, your 529 plan money could stay in taxable savings for retirement. In twenty years, the IRA option would have $6,500 more in it if your investments earned an average annual return of 7 percent and your tax rate remained at 30 percent.

As you can see, it’s not a straight forward answer of one or the other. If your child does go to college, the 529 plan offers serious tax benefits, especially if you live in a state that offers a tax deduction for 529 contributions. But if you have substantial taxable savings, or you ultimately don’t have any educational expenses, the Roth IRA could be a better option.

You certainly cannot know what the future holds for your child, so there is no wrong answer here. The important piece of the equation is that you are saving for her education in the first place. Whether you save in a 529 plan or an IRA is a secondary consideration. So save away, and don’t worry too much about whether you have the right type of account.

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