529 plan vs. Roth IRA: Here’s how families can use both to save for college

You don’t have to be a scholar to understand that college is expensive and only becoming even more so. After adjusting for inflation, college tuition has increased 747.8 percent since 1963,  according to the Education Data Initiative. And while public universities tend to be cheaper, their prices have gone up significantly, too, rising about 9.2 percent from 2010 to 2022.

If you have to foot the bill, you’ll want to maximize your savings by taking advantage of every available option. Before using a normal taxable account or having to take out a student loan, you’ll want to look at the 529 savings plan, which was created to assist in paying college bills. But you might also consider using your Roth IRA, because of its many tax advantages.

Here are the pros and cons of using a 529 or a Roth IRA to pay for college.

What is a 529 plan and how does it work?

A 529 plan, also called a qualified tuition plan, is a tax-advantaged savings plan sponsored by states, state agencies or educational institutions.

It can come in one of two versions:

• Prepaid tuition plans, in which the saver purchases credits at participating universities for future use. Plans typically do not cover room and board.
• Education savings plans, in which the saver opens an investment account to pay for qualified college expenses, including tuition as well as room and board.

The contributions to a 529 plan can grow tax-deferred, and any withdrawals from a 529 plan are not subject to federal income tax (and in many cases, state taxes, too) as long as they’re used for qualified educational expenses. A 529 plan can be used for college as well as for K-12 education. It can also be used for vocational and trade schools.

Savers don’t get an immediate tax benefit from the federal government for contributing to the plan, as contributions are made on an after-tax basis. However, many states do offer tax deductions or credits for contributions.

In addition, the contribution limits can be higher for 529 plans than they would be for an IRA.

While the maximum contribution in each state’s plan may differ, any contributions over the maximum gift tax exclusion – $18,000 for 2024  – could make you liable for gift taxes. In contrast, the Roth IRA lets you put away $7,000 (for 2024) for those under age 50, while those over 50 can save an additional $1,000 a year.

The 529 plan can also be a useful vehicle for extended family to help pay for college.

“Anyone can contribute to a 529 plan – this is an opportunity for relatives to assist in funding,” says Philip D’Unger, a certified financial planner at CAPTRUST. And if they’re overfunded, “these accounts can be rolled to a 529 plan for the benefit of other family members.”

Pros and cons of 529 plans

A 529 plan offers many advantages, but it may not be right in every situation for everybody.

529 plans offer big tax savings for education

“529 savings accounts are an incredible tool that provides savers with a combination of state income tax deductions, tax-deferred savings, and tax-free distributions for qualified educational expenses,” says Joshua C. Young, a wealth advisor at BakerAvenue Wealth Management in Sun Valley, Idaho.

Those are the biggest positives of such plans, but 529 plans also offer an advantage over the Roth IRA, especially for parents who are on the younger side.

529 plans may be better for younger parents

“Since earnings cannot be withdrawn from a Roth IRA prior to age 59½ without paying taxes, parents who will be under that age when their child is in college will likely be better off investing in a 529 plan,” says Jim Mahaney, principal at Mavericus Retirement Services in Montclair, New Jersey.

Note that this caveat applies only to the earnings in a Roth IRA, not the contributions, says Morris Armstrong, founder of Morris Armstrong EA, a tax preparation firm. “If you are younger, the amount of your basis will come out first (your contributions) and be tax-free.”

529 plans can be somewhat inflexible

One of the biggest downsides of 529 plans used to be their inflexibility. After all, contributions could only be used to pay for educational expenses. But that changed in 2024, as part of SECURE Act 2.0.

Now, unused money in a 529 plan can be converted into a Roth IRA. The rule allows beneficiaries to convert a lifetime total of $35,000 from a 529 plan to a Roth IRA without incurring taxes or penalties.

However, the new rule comes with some limits, namely that the 529 account must be open for at least 15 years before a conversion can take place. So while the new provision starts in 2024, you might need to wait a while to take advantage of it.

If you’re unable to use the money for qualified expenses or roll it over to a Roth IRA, you may have to withdraw the money. In that case, you’ll owe income taxes on the earnings – but not the principal you contributed – and you’ll be assessed an additional 10 percent penalty on any earnings that you withdraw.

But there are alternative ways to use the funds without incurring taxes or penalties: change the beneficiary to a sibling or other family member, pay for your own ongoing education or save the money for a grandchild, among other options. And thanks to another recent rule change, beneficiaries can use a 529 plan to pay off student loans for themselves and siblings, up to $10,000 each.

Investment options are limited in a 529 plan

In addition, education savings plans may offer only a set choice of investments, so that you’re unable to invest in exactly what you want. You’ll typically have a choice of fund portfolios, and the range of options may not meet your needs.

What is a Roth IRA and how does it work?

A Roth IRA is a type of IRA that allows you to save money in a tax-advantaged account and then withdraw it tax-free in retirement, which is considered to be age 59½. So savers contribute after-tax money today in order to get a tax break tomorrow. (That’s in contrast to a traditional IRA, where the tax break comes today.) The Roth IRA allows you to contribute a maximum each year – $7,000 in 2024 – and an extra $1,000 catch-up contribution for those 50 and older.

The Roth is especially flexible because of how it allows the saver to withdraw money.

“For someone under the age of 59½,” Mahaney says, “money contributed to a Roth IRA can be withdrawn tax-free and penalty-free if used for higher education expenses, assuming the account has been open at least five years….For anyone over the age of 59½, however, withdrawals of both contributions and earnings are both tax-free and penalty-free.”

Pros and cons of Roth IRAs

Roth IRAs offer many advantages for savers, but it’s important to remember that they’re meant for retirement.

A Roth IRA offers significant tax benefits

“Roth IRA accounts have the same taxable benefits as a 529 account,” says Matt Boelter, senior director of financial planning at Edelman Financial Engines. “They also have the added benefit of not being limited to paying for school.”

A Roth IRA offers maximum investing flexibility

The Roth IRA also offers benefits in terms of available investments, unlike the 529, where investment choice is limited to funds that may not offer low-expense options. That’s not the case with a Roth, which allows you to invest in nearly anything that trades on a public market.

“In a Roth, you can luck out with Apple or Netflix, or plod along with a portfolio of low-cost index funds representing the market,” says Armstrong. “You have substantially more control over the Roth account.”

A Roth IRA offers flexibility for relatives to support a student

Boelter says that it’s common to see grandparents use a Roth IRA for a grandchild’s education. He sees older investors converting some of their traditional IRA assets to a Roth IRA, though they spread out the conversion over years in order to minimize the tax bite of the conversion.

This approach has several benefits, says Boelter: “It reduces their future required minimum distributions from the traditional IRA, allows the grandparent to keep more control over the money, and the money doesn’t get counted against financial aid.”

Roth IRAs may hurt financial aid chances

But it’s important to understand how the Roth IRA affects financial aid.

“Families applying for financial aid under the federal methodology will want to keep in mind that Roth IRAs are not reported as an asset on the Free Application for Federal Student Aid form,” says Mahaney.

However, Roth IRAs can affect a student’s eligibility for aid if distributions are made from them.

“Income has a larger impact on the FAFSA calculation than savings does,” says D’Unger. “Withdrawals from a Roth IRA would count as income for the FAFSA form even if it is not taxable, which would have a significant impact on future eligibility.”

529 plan vs Roth IRA: Which one is better?

If you’re trying to pick the best account to save for your child’s education, 529 plans and Roth IRAs are both solid options.

Sure, a 529 plan is specifically meant to help you save for education and a Roth IRA is intended for retirement. But both accounts offer the same attractive tax advantage — the ability to grow your money and enjoy tax-free withdrawals in the future.

They both impose stipulations on those withdrawals, though. You’re penalized 10 percent if you withdraw earnings from a Roth IRA prior to age 59 ½, and you’re penalized 10 percent if you withdraw earnings from a 529 plan for non-educational expenses. In both cases, you’ll owe income tax on those withdrawn earnings, too.

While a Roth IRA offers the most investment choices, more 529 plans are offering low-cost fund options. Contributing to a 529 can also come with state tax breaks as well as no aggregate contribution limits.

You can fund both accounts for your child at the same time, using the Roth IRA as a backup account to supplement education costs. Now that up to $35,000 from a 529 plan can be rolled over to a Roth IRA over the course of the beneficiary’s lifetime, you don’t really need to pick one account or the other. You can fund a 529 plan now and convert a sizable chunk of money unused for educational expenses into a Roth IRA down the road.

“529 plans will provide the best benefit for college savings,” says D’Unger. Meanwhile, the Roth IRA “is generally beneficial for education savings when the saver is unsure of the intended use of the funds or needs to save for multiple goals in one account.”

Ultimately, the best account to use for college expenses depends on how much you can afford to save, your child’s education goals, available state tax deductions and your income. Both accounts can help you efficiently save for a child’s future — which is the ultimate goal.

Bottom line

As tuition costs continue to rise, it’s important for families to consider their options for saving for higher education. While both 529 plans and Roth IRAs offer tax benefits, they each have unique strengths and potential drawbacks. By understanding the features of these account and using them strategically, families can maximize their savings and make college expenses more manageable. With the right information and planning, parents can ensure a bright future for their children.