(MoneyWatch) If you want to put some money aside for college tuition, room and board, and other costs, there are several types of plans or accounts to consider for short- or intermediate-term college savings. Among these are 529 plans and Roth IRAs for education savings goals.
Roth IRAs for college savings
A student who wishes to put away funds for college can do so by making contributions to a Roth IRA, but he or she must have earned income equal to or more than the amount of the contribution. Dividends and interest income don't count as earned income. Plans and investment options vary with the financial firms offering this account.
Funds invested in Roth IRAs may be withdrawn before earnings and used for any purpose, including education, without tax or penalty.
However, a Roth IRA is a much better retirement vehicle than a college-savings vehicle. Earnings from a Roth may be distributed tax-free after the account owner reaches age 59 1/2 and satisfies the five-year holding requirement. But earnings withdrawn before that age are taxable even when used for college expenses. (The 10 percent early distribution penalty may be waived under the special exception for higher education expenses.)
Many parents are surprised by the potential financial aid penalty: The entire IRA distribution, taxable or not, must be included in base-year income on the student's federal financial aid application for the following year. This can reduce the amount of need-based financial aid.
529 education savings plans
These plans are state-sponsored savings and investment programs. The state creates the plan through an asset management company with which savers open a 529 account. Typically, the parent is the owner of the account, and the child is the beneficiary. The asset management/investment company manages the investment fund options and provides customer service for the plan.
The benefits of 529 plans include:
1. The account owner does not pay income taxes on the account's earnings.
2. The owner/parent always has control of the account -- not the beneficiary/child.
3. If the beneficiary/child doesn't go to college, the account can be transferred to another family member and used tax-free for their qualifying education costs.
4. Anyone can contribute to the account.
5. There are no income limitations that might make someone ineligible for an account.
6. Most states have no age limit for use of the money.
Also, if the 529 account beneficiary gets a scholarship, an amount equal to the scholarship award can be withdrawn without paying the 10 percent penalty. The account owner will have to include the earnings withdrawn from the account as taxable earnings.
Many 529 plans have a menu of investment fund options that include lower-risk stable value, principal preservation or intermediate-term bond funds as well as higher-risk stock funds to which investors can allocate their savings.
For these reasons, as a vehicle for college savings, a 529 plan is recommended over a Roth IRA.