Investing

529 vs. Roth IRA: Who Wins?

When you begin to look at saving options with the long-term goal of sending your kids to college, two options tend to bubble to the surface: a 529 plan and a Roth IRA. A Roth IRA is commonly used as a retirement account, not necessarily for college. But the Roth is flexible enough to compare closely with the college-focused 529 plan.

The rules for both plans are similar. As long as you don’t withdraw investment earnings early, your investments will grow over time tax-free. So which plan is best? Let’s find out.

What Is a 529?

Like a Roth IRA, a 529 plan is a tax-advantaged way to save money. But unlike a Roth IRA, the 529 plan is designed specifically to save for education costs. Legally, 529 plans are referred to as “qualified tuition plans.”

A 529 comes in two different forms: education savings plans and prepaid tuition plans. Every state sponsors at least one type of 529 program. So what is the difference between the two?

Prepaid tuition plans are generally run through state governments and come with a residency requirement for either the beneficiary or the saver. There are a few drawbacks to prepaid plans. Some governments guarantee the money that goes into the account, but some do not. Prepaid plans may also place restrictions on which college or university participates in the program. If your child does not go to a participating school, the return on your investment can be minimal.

Education savings plans are more flexible. A saver can open an account and use the proceeds for all tuition, room and board, and any mandatory fees. Most of the time, all colleges are qualified to have these expenses paid for by an educational savings plan. In addition, you are allowed to use $10,000 from an educational savings plan to pay for any private school, religious elementary school, or secondary school.

One of the benefits of a 529 plan is there are no contribution limits. However, each contribution is viewed as a gift, and the maximum amount you can gift at a tax-free rate is currently $15,000.

What Is a Roth IRA?

The Roth IRA was built to encourage people to save for retirement, but the only restriction it places on early withdrawals is on the earnings from your investments. This means that you can take out your contributions at any time tax-free without penalty.

For example, the most you could contribute to an IRA plan in 2019 was $5,500. That number went up to $6,000 for 2020. Every few years, the contribution limit is raised to keep up with inflation. For this example, let’s assume that every third year the limit goes up by $500.

If you contributed the maximum amount of money for the next 18 years, here is how it would look:

  • 2020: $6,000
  • 2021: $6,000
  • 2022: $6,500
  • 2023: $6,500
  • 2024: $7,000
  • 2025: $7,000
  • 2026: $7,500
  • 2027: $7,500
  • 2028: $8,000
  • 2029: $8,000
  • 2030: $8,500
  • 2031: $8,500
  • 2032: $9,000
  • 2033: $9,000
  • 2034: $9,500
  • 2035: $9,500
  • 2036: $10,000
  • 2037: $10,000

By the beginning of 2038, you would have contributed $144,000 to this account. And all of it can be taken out tax-free. If you were to have a baby in 2020 and wanted to start saving in a Roth IRA, you would be able to cover $36,000 worth of college costs each year for four years. (For more on the cost of college, head here.)

Note that your Roth IRA should still have a significant amount of money saved up beyond your initial contributions. For example, if your contributions were to reach $150,000 in the next 18 years, and if we assume a return rate of 5% per year, the investment earnings in your account would total $100,000.

There is also the option of investing in a Roth 401(k) plan, which currently has a contribution limit of $19,000. And since you have the option of investing in both a Roth 401(k) and a Roth IRA, the total amount you could potentially save each year at a tax-free rate is $25,000.

A Roth IRA is a fantastic investment tool, but its availability has an income requirement. If you are a single filer making more than $137,000 or married filing jointly and make over $203,000, you will not be eligible. Note that earnings and profits from properties, interest and dividend income, and pension or annuity income do not count towards this total.

529 vs. Roth IRA: Who Wins?

The best choice when picking between a 529 and a Roth IRA may come down to the state that you or your child lives in. If your state only offers a prepaid tuition plan, you may want to more seriously consider a Roth IRA. The restrictions placed on some prepaid tuition plans make them shaky investments at best. Your money is most likely better used in a Roth IRA.

What makes the Roth IRA the winner in this contest is its flexibility. What if your kid doesn’t want to go to college? In that case, any benefits of a tuition plan go out the window. Your child may also prefer a college that is not participating in the program or prefer a trade school. In this case, you may be forced into an uncomfortable conversation with your child or spouse.

With a Roth IRA, if life throws you a curveball, you can adjust the goals of your investment plan. With a 529 plan, you are committing in advance to using the money explicitly for schooling and sometimes only for specific schools.

One of the main benefits a 529 has over a Roth IRA is that anyone can contribute to another person’s plan. A 529 plan may also be the best option if you make too much money to qualify for a Roth IRA.

The Bottom Line on 529 vs. Roth IRA

If you know for sure that college is in your child’s future and want to get a head start, an educational savings plan might be the right choice for you. But if you want to keep your options open, a Roth IRA presents you with the most value.

No matter which plan you choose, you will have your choice of mutual funds, exchange-traded funds, and bank funds to choose from. The amount you can ultimately earn through these plans is dependent on the contribution limits and the performance of the investments.

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