Sparing your kids from the burden of student loans is the best thing you can do for them. We’ve already discussed college savings plans you can set up since they’re born, but what about using your retirement accounts?
If you’re relatively new to personal finance and didn’t find out about 529 savings plans, or prepaid plans, other savings can cover your kids’ college expenses. If you have a Roth IRA, you can use the funds for your children’s college expenses.
Although the primary purpose of a Roth IRA is to stimulate retirement savings and ensure tax-free withdrawals in retirement, it’s often an option to finance your children’s education.
If you’re looking for a hint of what college savings option to choose, the answer is preferably both.
Both Roth IRA and a 529 plan can work great in covering college expenses and cutting your taxes. Some rules apply to both savings accounts, so make sure you go through our detailed explanation before deciding.
If you’re late on college savings and sure the beneficiary will attend university, a 529 college savings plan is a better option. It comes with no income limit and higher contributions limit. But a Roth IRA is more versatile, flexible, and can be used for long term savings.
Advantages of a 529 College Savings Plan
A 529 plan is similar to a Roth IRA, with its primary purpose being college savings. A parent, grandparent, or relative can open the account on the beneficiary name and make contributions from $14,000 to $28,000 per year.
Higher contributions limit than other savings options
If you were in an unfortunate position earlier in your life when your kids were little, and you couldn’t put away money for their higher education, a 529 plan is a great choice.
In roughly 5 years, you can save enough to pay for most of your kid’s college expenses.
The limit is $14,000 for a single contributor and $28,000 for a married couple. You can even dump a lump sum of $75,000 as a front payment and still be free of gift taxes.
Wide area of expenses coverage
The 529 doesn’t only cover tuition expenses but other education expenses too.
In fact, a 529 plan cover the education expenses from kindergarten to university. Additional learning materials, technology, housing, food, and special needs equipment are counted as education-related expenses by the IRA.
Optional beneficiary transfer
Say your older kid is the beneficiary of the 529 plan, and they choose not to attend university; you can change the beneficiary to another person.
The list of qualified beneficiaries is long; it can be your other child, nephew, or yourself. If you have any college debt, you can put yourself as the beneficiary and pay it off with the 529 plan.
Other contributors are welcomed
Grandparents, relatives, and even non-blood-related family friends can contribute to your 529 plan. A 529 program accepts third-party contributions, so anyone who wants to help the beneficiary’s education is welcomed.
Disadvantages Of 529 College Savings Plan
As good as it may sound, the 529 savings plan does come with some disadvantages.
You can only assign one beneficiary per plan, so if you have more than one kid, you need more than one 529 plan.
You must use the money you contribute in a 529 plan for qualified education expenses. You can check the list of approved education expenses by the Roth IRA before putting something on your 529 plan.
Since the 529 plan is not intended to earn you money, the investment options are limited. You can choose from up to 11 investment funds. They usually offer more conservative investment programs that will keep your money safe but not tremendously growing.
Flexibility is not a perk of the 529 plan. Withdrawing money for other things except education costs comes with a 10% penalty. You would also have to pay income tax on the sum you’ve withdrawn.
Advantages Of A Roth IRA As College Savings Fund
Roth IRA is an individual retirement account, but it’s flexible enough to be used for education expenses. When 529 seems like a strict option for college savings, you might want to consider Roth IRA. Here are some cases when Roth IRA is preferred over a 529 college savings plan.
More Flexible Than 529 Plans
While a 529 plan obligates you to spend the savings for education-related expenses, the Roth IRA is flexible. If your child decides they don’t want to attend university, you’re not obligated to search for another beneficiary.
With Roth IRA, you won’t lose your savings; on the contrary – the contributions you’ve already made are your retirement savings.
Free Education-Related Withdrawals
Roth IRA withdrawals are 100% penalty and tax-free only when you make them after you’ve turned 59 ½ years. But there is an exception for free early withdrawals, and that’s educational expenses!
If you decide to withdraw an amount equal to your contributions from your Roth IRA to pay for your child’s college, you can do it and not pay any taxes or penalties.
For example, you’ve contributed $30,000, and over time they’ve grown to $45,000. You can withdraw $30,000 without penalties or taxes.
If you decide to withdraw the full amount, including earning, that will be $45,000, and you will be taxed but won’t face any penalties.
More Investment Opportunities
With a 529 college savings plan, you have a limited choice of a more conservative and targeted investment plan or mutual funds.
With Roth IRA, you have a more expansive list of investment options, and you can create a custom investment strategy. You could minimize your investment cost and explore more profitable technique than with a 529 plan.
Disadvantages Of Roth IRA As College Savings Fund
Roth IRA’s primary goal is not a college savings account, so you’ll face some disadvantages when deciding to use it as one. The tax benefits, low penalties, and flexibility sure sound tempting, but beware of the downsides before you choose.
Unlike the 529 plan, Roth IRA has limited yearly contributions of $6,000 or catch-up contribution of $7,000 when you’re over 50.
A lower contribution limit expands the time needed to save for your kid’s college expenses. While a $6,000 yearly contribution is significant retirement savings, it might not be enough for nearing college expenses.
You’ll Sacrifice Your Retirement Savings
Thinking of your children is a responsible thing to do, but you shouldn’t forget about your retirement days. Using up funds from Roth IRA will leave you with lower savings for retirement.
While there are other options for retirement savings, the Roth IRA is an excellent one. Sacrificing it to pay for your kid’s college it’s not a smart financial decision to make.
High Income Individuals Are Not Eligible
Roth IRA doesn’t only have contribution limits but income limits too.
Your modified adjusted gross income must be under $139,000 if you file as an individual or under $206,000 for joint filers.
You can only contribute earned income to your Roth IRA, so you can’t contribute a lump sum, for example. This means any money you make from selling a property, dividends from stock, you can’t put it towards Roth IRA.
Limiting Your Child’s Chances For Financial Aid
Withdrawals made from Roth IRA or other retirement savings accounts are counted as earned income for financial aid eligibility.
It sounds confusing, but even if your Roth IRA withdrawals are not taxed as income, they will lower your kid’s chances of receiving financial aid while in college. You could prevent this by withdrawing the necessary funds at your child’s final year of education, but what if you need the money sooner?
Of course If your child doesn’t plan on applying for financial aid while in college, using funds from the Roth IRA will not affect them.
So Which College Savings Account To Opt For?
Carefully consider your children’s preferences, plans, and wishes. Parents tend to have high expectations from their kids and aim to save for college. But not every kid wants to attend an Ivy League university.
If your child is still too young to choose a career path, opt for a Roth IRA savings. Even if they decide to pursue a career not connected with a university degree, you’ll have the money saved for your retirement days.
If your child is older, closer to their college enrollment day and already know they want to pursue higher education, opt for a 529 plan. You can make more significant contributions, include your extended family in the saving process, and help out your child.
Financial decisions need to be discussed and made with your family. If you prefer more freedom in contributions and despise limitations, opening an independent investment account is always an option.
This way, you can give your children the benefit of using the money you saved for them to open a small business if they don’t want to continue their education.
Frequently Asked Questions
Can my kid open a Roth IRA?
A parent or custodial can open a Roth IRA that the kid can contribute to with any earned income. Minors can’t have independent Roth IRAs until they turn 18.
Can you payoff student loans with Roth IRA?
You can pay off your student loan debt with the contributions and earnings from a Roth IRA without paying any penalty.
What if I have money left over in my 529 plan?
You can use any leftover money in your 529 plan to pay off student loan debt, transfer to another child within the family, or withdraw as a non-qualified expense.
Unlike Roth IRA, where contributions and earnings are separated, and you can make a principal-only withdrawal, with 529 plans, any withdrawal consists of contribution and earning.
So if you have gains in your withdrawal, you will pay taxes and a 10% penalty on the earnings portion of the non-qualified withdrawal.
Do I need separate 529 plan for each child?
Technically you can use one 529 plan for several children, but it only makes sense if they’re more years apart. For example, the funds from one 529 plan might not be enough to put two or three kids through college in 5 years.
With separate 529 plans, you can choose a targeted date investment plan in correlation with each child’s age.
In the end, it looks like the Roth IRA tends to win most of the time, but it’s wise to review the details for yourself and see how your unique life situations allow for either the 529 plan or the Roth IRA to be the best choice.
Have you chosen a college savings account yet? What are your thoughts on specialized college savings accounts vs. regular investment accounts?