For several decades, parents have had the option of saving for college through 529 plans. Although Section 529 of the Internal Revenue Code didn’t appear until 1996, the first such plan is generally recognized as the Michigan Education Trust, which began in 1986.
While based in part on Federal tax law, each state must sponsor its own 529 plan. Making decisions more complex, you aren’t limited to using the 529 plan in your state. You can choose another state’s 529 plan if you like.
Complicating matters further is the option to use a Child IRA (specifically, a Roth rather than a traditional tax-deferred IRA). These Roth Child IRAs present an array of advantages, and some disadvantages, prompting many parents to ask themselves which savings option – the 529 Plan or the Roth Child IRA – is best for their child.
“This really depends on what the funds are intended to be used for,” says Jason Field, Financial Advisor at Van Leeuwen & Company in Princeton, New Jersey. “529 plans only offer advantages if used for education purposes, where the Roth IRA can be used for education and certain other purposes before the age of 59½.”
Despite being designed for different purposes, both choices offer the same critical benefit most parents are looking for.
“Contributions grow tax-free in both a Roth IRA and a 529 plan,” says Jazmin Gabriela Carpenter, VP, Investments at Wedbush Securities in Los Angeles. “A Roth IRA is designed to be a retirement saving vehicle while a 529 plan is specifically designed to be an education savings vehicle. You can withdraw from a Roth IRA for higher education expenses but it is limited. Roth Child IRAs are more flexible because contributions can be withdrawn at any time.”
On the face of it, 529s offer a way to amass substantial savings in a short period of time.
Roth Child IRA contributions, like any other IRA, are limited to a maximum of $6,000 per year for those under 50 years of age. Furthermore, those contributions are reduced if the earned income for the tax year they apply to is less than $6,000.
In contrast, 529 plans do not require contributions to be offset by earned income. In addition, there is no statutory annual cap to contributions. There are, however, practical limits, but those limits apply to individual contributors, and the 529 plan can have multiple contributors (for example, parents, grandparents, aunts, uncles, friends, Bill Gates, virtually anyone).
The practical limit for 529 plans is the $15,000 annual gift exclusion per person. That means individual parents can each contribute up to $15,000 before meeting this maximum. That’s $30,000 from the parents alone. And there are ways to exceed this (although they may impact one’s lifetime estate strategy).
While 529 plans offer the advantage of virtually unlimited contributions in any one year, they suffer from a lifetime cap (which varies from state to state). This cap ranges from $235,000 for Georgia’s Path2College 529 plan and Mississippi’s plans to $542,000 for two of New Hampshire’s three 529 programs. These caps are based on expected lifetime college costs.
You can contribute more and grow the funds faster in a 529 plan, but once you reach a certain size, you can’t continue to contribute (although the funds can still grow). On the other hand, a Roth Child IRA has no upper limit.
So, which is better for you?
“It isn’t necessarily ‘better,’ it’s just different,” says Mike Cocco, Financial Professional at Equitable Advisors in Nutley, New Jersey. “For retirement purposes, Roth IRAs can certainly be better due to their long-term nature and the ability to use those funds for anything. However, 529s are better for college costs, as people can access the money tax-free at a much younger age, but the money must be used for college costs (or up to $10,000/year in a private high school).”
But what happens if your child doesn’t need the money for education? Most parents can’t predict their children’s collegiate future. Will they win a scholarship? Will they go to a less expensive school? Will they qualify for financial aid? Will they even go to college?
This uncertainty begins to tip the scales in favor of Roth Child IRAs (assuming your child has earned income).
“Where the Roth IRA is the winner, is its flexibility,” says Dominic Trupiano, VP of Sales & Marketing at Artesys (R.T. Jones Capital Equities Mgmt, Inc.), located in St. Louis. “If the child does not need or want to use the funds for education, the money can continue to grow in the account or be used to buy their first home. Contributions to the Roth can be withdrawn tax and penalty-free, but earnings are taxed before age 59½.”
This gives the Roth Child IRA a major advantage over the 529 plan.
“Deposited funds are all available for college expenses and all funds are available later in life for retirement,” says Jonathan DeYoe, President of Mindful Money in Berkeley, California. “This means that funds not used for education are available for other purposes without additional taxes or fees. The funds can compound for much, much longer.”
In addition, the FAFSA form used for determining eligibility to receive student aid requires you to list all 529 assets. It doesn’t have a similar requirement for retirement assets, including Child IRAs.”
Carpenter says “529 plans are likely to reduce student financial aid. The funds in the Roth Child IRA won’t be used to determine income when filing for student aid.”
Still, if you can afford it, why not enjoy the best of both worlds?
“I personally don’t believe one is better than the other,” says Carpenter. “Why not fund both (subject to eligibility)?”
Which one is right for you? There are a lot of factors, including not only your own personal situation but quite possibly the state you live in. Because of this, you can’t rely solely on something you read to get the definitive answer. It should help you begin to know the right questions to ask, but, as with many things, you’ll need to consult an expert (or two) if you want to get closer to what’s right for your specific set of circumstances.