Note on 529 plans
Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.
According to an article in The Wall Street Journal (“More Parents Are Becoming 529 Dropouts,” November 11, 2009), after the 2008/09 market collapse, some investors–and financial advisors–have reduced their reliance on 529 plans. Some of this pullback can be attributed in part to a broader retreat from the stock market as a whole. But another part can be attributed to parents who have opted to trade the tax benefits of 529 plans for college savings vehicles that don’t have a “must-beused- for-college” restriction. And as parents seek to save for their own retirement too, one such vehicle is a Roth IRA. So, just how does a favorite of the college savings world, a 529 college savings plan, stack up to a favorite of the retirement savings world, a Roth IRA, as an education-funding vehicle?
Tax benefits
Both 529 college savings plans and Roth IRAs offer federal tax-free earnings if certain conditions are met (and most states follow this tax treatment), but only 529 plans offer the possibility of a state tax deduction too.
For 529 plans, earnings are tax free at the federal level if the distribution is used to pay the beneficiary’s qualified education expenses –a broad term that includes tuition, fees, room and board, books, and computers–at any accredited college in the United States or abroad. If the distribution is used for any other purpose, earnings are subject to income tax and a 10% federal penalty tax.
For Roth IRAs, earnings are tax free at the federal level if the distribution is “qualified.” A distribution is qualified if a five-year holding period requirement is met and one of the following conditions is met: (1) you are at least age 59½; or the distribution is made (2) due to a qualifying disability; (3) to pay certain firsttime homebuyer expenses; or (4) by your beneficiary after your death.
If you are younger than age 59½ and you have a taxable distribution, you will also pay a premature distribution tax (also called an early withdrawal penalty) equal to 10% of the earnings portion of the distribution. But there are exceptions to this penalty, and one is if the money withdrawn is used to pay your child’s qualified higher education expenses.
Bottom line: if you withdraw money before age 59½ to pay your child’s college expenses, you’ll generally owe income tax on the earnings, but not an early withdrawal penalty.
However, you may not end up owing income tax on the earnings, because Roth IRA distributions generally aren’t taxed as earnings until the principal has been fully withdrawn. (By contrast, a distribution from a 529 plan is considered part principal and part earnings.)
Financial aid
There is an important difference here. Under federal financial aid rules, 529 plans are counted as a parent asset (if the parent is the account owner), and 5.6% of all parent assets are deemed available for college costs. By contrast, the federal aid methodology doesn’t count retirement assets in determining aid eligibility. So a Roth IRA won’t impact the amount of federal aid your child may be eligible for. However, although Uncle Sam doesn’t count retirement assets, colleges typically do when awarding their own institutional aid.
Investment choices
Roth IRAs have the edge here–you can choose from a wide range of investments to fund your Roth IRA, and you can buy and sell investments whenever you like. But with a 529 plan, you are limited to the investment options offered by the plan. If you’re unhappy with the investment performance of the options you’ve chosen, most plans let you change the investment options for your future contributions at any time, but for existing contributions, you can only change investment options once per year (twice per year in 2009 only). In 2008 and 2009, this restriction proved costly for many 529 account owners: having reached their limit on investment changes for the year, they were unable to make further changes in response to deteriorating market conditions.
Lump-sum contributions and eligibility
If you have a lump sum to contribute, 529 plans allow individuals to gift up to $65,000 in 2010 ($130,000 for married couples) and avoid gift tax if certain conditions are met. By contrast, Roth IRAs have a contribution limit in 2010 of $5,000 ($6,000 for individuals age 50 or older). And your ability to contribute to a Roth IRA depends on your income level. But anyone can contribute to a 529 plan–there are no restrictions based on income.
Bottom line
Whether a Roth IRA or a 529 college savings plan is best for your college savings depends on your personal circumstances and the factors discussed here.
