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529 Plans or Roth IRA: Which to Use for College Savings?

In my previous post, I started answering a reader question about what to invest in to pay for two children that are going to college, one next year and the other in 2015. I wrote that I wouldn't consider either of those time horizons to be long term when it comes to investing money, and cautioned on limiting the use of stock funds for these goals. I also wrote about the use of several types of plans or accounts worth considering for short or intermediate term college savings, including Prepaid Education Arrangements, 529s and Roth IRAs. Today I'll finish my answer by sharing a few thoughts on using 529 plans and Roth IRAs for education savings goals:

529 Education Savings Plans. These are state-sponsored savings and investment programs. The state sets up the plan with an asset management company of its choice, and you open a 529 account with that asset management company. 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:

  • The account owner does not pay income taxes on the account's earnings.
  • The owner/parent always has control of the account - not the beneficiary/child.
  • If the beneficiary/child doesn't go to college, the account can be transferred to another family member.
  • Anyone can contribute to the account.
  • There are no income limitations that might make someone ineligible for an account.
  • Most states have no age limit for when the money has to be used.
  • If the child gets a scholarship, any unused money can be withdrawn without paying any penalty (the owner will include the earnings as taxable income taken out of the 529 plan account).
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 where investors can allocate their savings. Check out my favorite web site to find and compare 529 Education Savings Plans.

Roth IRA. Another option is to have your student make contributions to a Roth IRA instead of the parent saving in a 529 Plan. In order to be eligible to contribute to a Roth IRA, your student must have earned income equal to or more than the amount of the contribution (Note: dividends and interest income don't count as earned income). Money in a Roth IRA can be invested in much the same way you can invest in a 529 plan, and the availability of investment options is dictated by the financial company that provides the Roth IRA account.

One good thing about a Roth IRA is that contributions can be taken out before the earnings. In addition, the contributions portion can be used for any purpose, including education, without tax or penalty.

But I've always said that a Roth IRA is a much better retirement vehicle than a college-savings vehicle. Earnings on a Roth can be distributed tax-free after the account owner reaches age 59½, as long as the money has been in the Roth IRA for at least five years. But earnings that come out before age 59½ are taxable even when used for college expenses (however, the 10-percent early distribution penalty may be waived under the special exception for higher-education expenses.)

The surprise for many parents is the potential financial-aid penalty of using a Roth IRA: 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.

For these reasons, it's recommended to use a 529 plan to save for intermediate- and longer-term college savings goals.

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