Should I convert my Roth IRA into a 529 plan?

When it comes to saving for education expenses, there are a few different options available. Two of the most popular choices are the Roth IRA and 529 plan.

While both accounts can be used to save money for education, they have different rules and tax implications. Understanding the differences between these two can help you make an informed decision about which one is best for your situation.

Roth IRA vs. 529 plan: Key differences

Both the Roth IRA and 529 plan are accounts used to save money for the future, but there is a key difference: Roth IRAs were designed to save money for retirement while 529 plans were created to save money for education. There are other key distinctions between the two:

The two types of accounts are somewhat similar when it comes to allowing distributions to be spent on qualified education expenses. In the case of 529 plans, money withdrawn from the plan is not subject to taxes when used for such qualified education expenses as room and board, tuition, fees and books.

It’s also possible to use funds from a Roth IRA to cover education costs. In the case of a Roth, money withdrawn for education expenses is exempt from penalties when used to pay for education expenses. But unless the account owner is over the age of 59 ½, taxes must be paid on such withdrawals.

Roth IRA to 529 transfer: Pros and Cons

If you are thinking about transferring money from your Roth IRA into a 529 account, here are the benefits and drawbacks to keep in mind.

Pros

• Higher contribution limits: The IRS doesn’t specify contribution limits for 529 plans. While 529 plans set their own contribution limits, these are often designed to cover several years of full-price tuition.
• State tax incentives: The IRS doesn’t allow federal tax deductions on 529 plans. But your state might provide tax breaks on your contributions.

Cons

• Taxable distributions: With a Roth IRA, you may have to pay an early withdrawal penalty if you’re younger than 59 ½. To avoid the penalty, you would need to use the distribution for education expenses instead of putting the money into a 529.
• No federal tax perks: There are no federal tax deductions for 529 contributions, though you may get a tax break from your state.
• Aggregate limits: Every state sets a limit on the total amount you can contribute to 529 plans over a lifetime. The limit applies to each beneficiary and ranges from around $235,000 to $590,000.

Roth IRA to 529 plan: Education vs. retirement

Before transferring your money, it’s important to review the potential ramifications, along with your financial needs and goals. There are some scenarios where transferring money from a Roth IRA to a 529 plan makes sense.

Saving for education

If you were to use your Roth IRA for both retirement and education savings, you may not be able to save much for retirement since you hit the annual Roth contribution quickly. In this case, it may make more sense to pull money from the Roth that’s earmarked for education and transfer it to a 529 plan, but this decision has its drawbacks.

“One of the biggest downsides is that once the funds are in a 529 plan, they must be used for education or face penalties, limiting future flexibility,” says Rachel Gustafson, CFP, CCPS, an investment advisor with Financial Investment Team (FIT). “Additionally, withdrawing funds from a Roth IRA to fund a 529 plan can lead to an opportunity cost, as those funds lose the ability to grow tax-free for retirement.”

Saving for retirement

Keeping funds in a Roth IRA is often the better choice if saving for retirement is your primary goal for the money. In addition, maintaining the funds in a Roth can be more beneficial if financial flexibility is important to you, as Roth IRAs allow funds to be used for a variety of purposes, including both retirement and education, while 529 plans do not offer this type of flexibility.

“If a student receives a scholarship that reduces the need for education savings, keeping funds in a Roth IRA allows the owner to repurpose those funds for retirement rather than being restricted to educational expenses,” says Gustafson.

Roth IRA: Pros and cons

There are benefits and drawbacks to using a Roth IRA to save money for education expenses.

Pros

• Deposits and earnings are allowed to grow tax-free
• Deposits can be withdrawn tax-free at any time
• At age 59 ½ all funds in a Roth can be pulled out tax-free and penalty-free to cover education expenses

Cons

• Doesn’t provide state-income tax deduction for contributions
• Low annual contribution limit compared to 529 plan
• Roth funds used for education can impact financial aid awards to students

529 plan: Pros and cons

There are many benefits to using a 529 plan to save for educational expenses, but it’s important to also be aware of the disadvantages associated with 529 plans.

Pros

• No annual limit to how much you can contribute to a 529 plan
• Deposits and earnings are allowed to grow tax-free
• Available to anyone regardless of income level or age

Cons

• May require minimum monthly contributions in some states
• Contributions in excess of $18,000 count against lifetime gift tax exemption
• Limited investment choices compared to Roth IRA

Alternatives to 529 plans without using a Roth IRA

When it comes to saving for college, you have options beyond Roth IRAs. Here are some alternatives to consider:

• Savings accounts: Regular savings accounts, money market accounts and certificates of deposit offer safe, flexible ways to save. You don’t have to use the money for education expenses, which can be appealing if your child’s plans change. However, your return on investment will likely be much less than with a 529 plan or IRA.
• Brokerage account: You can also open a brokerage account and invest in just about anything, from stocks and mutual funds to bonds, currency and futures. There’s no penalty when you withdraw money, but you won’t enjoy any tax benefits as you would with a 529. Plus, earnings are subject to capital gains taxes, and you might have to pay brokerage account fees and commission fees, too.
• Coverdell education savings account (ESA): A Coverdell ESA is a type of investment account where you can choose how to invest your money. This offers more freedom than a 529 account, but the contribution limits are lower: $2,000 per year for each beneficiary, based on your income.
• Student loans: Another option is to take out federal or private student loans to cover the cost of college. We recommend starting with federal loans, which come with benefits like fixed interest for the life of the loan, income-driven repayment plans and student loan forgiveness in some cases. It’s also possible for parents to obtain federal loans to help their children cover the cost of college.

Bottom line

If you decide you would like to convert part (or all) of your IRA savings into a 529 college savings plan, be sure to read the fine print before doing so. There are benefits and penalties to consider when shifting money from one account type to the other.

Depending on the type of IRA you have, it may make more sense to withdraw funds directly from an IRA to cover education expenses. Understanding the best options for your situation can help you to maximize tax savings and avoid penalties.