I often get the question “Can I use a Roth IRA to invest for college?” While the answer is “yes,” the real question is whether you should. The comparison is typically drawn between 529 college savings plans and a Roth and, not to give away the punch line, a 529 is a Roth-like savings vehicle for college.¹
For starters, both the Roth IRA and 529 college savings plan are tax-advantaged accounts—you contribute after-tax dollars and, as long as the account is used for a “qualified” purpose, earnings grow tax-free. The reasons to consider a Roth for college funding are generally twofold: First, you can withdraw contributions tax- and penalty-free for any reason; and second, withdrawals that constitute earnings that are used for qualified higher education expenses are penalty-free. So the Roth IRA offers flexibility because the account can be tapped for nonretirement reasons (although you should carefully consider the impact on retirement savings and any potential income taxes).
But that’s essentially where the allure of the Roth for college ends. Here a few key benefits of 529s:
- 529s have much higher contribution limits. With a Roth, you’re limited to the annual IRA contribution limits (for 2014, $5,500 under age 50; $6,500 if 50 and over) and must have earned income (unless you’re making a gift to someone who has earned income so he or she can contribute to their Roth IRA). With a 529, you can contribute up to the annual gift exclusion ($14,000 in 2014) per donor per beneficiary without gift tax consequences. You can even front-load the 529 by contributing up to $70,000 per donor per beneficiary in a single year without incurring gift taxes, as long as you don’t contribute toward that student for four more years.²
- You may get a state tax deduction or credit in the year of your 529 contribution. Though it varies, some states offer a tax deduction for investing in a plan from any state.
- 529s offer unlimited participation—essentially anyone can contribute to a 529. Most plans allow contributions for beneficiaries of any age, and regardless of age, the account owner retains full control of the assets. In addition, you can change the beneficiary to an eligible family member of the original beneficiary (for example, if the first beneficiary gets a scholarship or doesn’t go to college). In contrast, your filing status and income could potentially eliminate or reduce your ability to contribute to a Roth IRA.
- If you take withdrawals from a Roth IRA for education, you may impact financial aid eligibility. Even though Roth assets aren’t considered an asset of the child (or parent, if funded by grandparents, for example) for the purpose of determining the financial aid formula, withdrawals would be considered income regardless of whether or not you pay any income tax. Distributions from 529s for qualified educational expenses, on the other hand, generally aren’t counted as parent or student income in the determination of federal financial aid eligibility.³
However, one argument for a Roth IRA is that 529s are more expensive. Although costs vary widely, these are state-sponsored, tax-advantaged plans, and there are program management fees on top of underlying fund expenses. So 529s will generally have greater all-in costs than their open-ended mutual fund counterparts. Keep in mind that advisor-sold plans cost more than direct-sold plans, and actively managed plans cost more than plans that follow an indexed strategy. Industry trends show that the cost gap between the average 529 expense ratio and that of the corresponding open-ended mutual fund category has narrowed to about 21 basis points.⁴
So, if you’re looking to pay for college, a Roth IRA is certainly an option, but consider the trade-offs and assess the impact on your retirement investing clock. But if you’re looking to invest for college, and contemplating a Roth or 529, the latter is generally the more appropriate tax-advantaged vehicle. If you’re not sure, it’s best to consult a tax advisor to discuss your personal situation.
1In addition, some college savers can also invest in a Coverdell Education Savings Account (ESA). Contributions to a Coverdell ESA are not tax-deductible, but earnings grow tax-free if used for qualified education purposes. There are income limitations for contribution eligibility, and total annual contributions cannot exceed $2,000. See IRS publication 970, Tax Benefits for Education, for more details.
² For married filed jointly, the annual exclusion per beneficiary is $28,000 and the front-loaded 529 contribution limit is $140,000 . Also note that, on a cumulative basis, you can generally contribute until your beneficiary’s total assets reach from $200,000 to $300,000 or more, depending on the sponsoring state.
³For more information on student financial aid information, visit FinAid.org.
⁴2014 Morningstar 529 College Plans Industry Survey.
For more information about any 529 college savings plan, contact the plan provider to obtain a Program Description, which includes investment objectives, risks, charges, expenses, and other information; read and consider it carefully before investing. If you are not a taxpayer of the state offering the plan, consider before investing whether your or the designated beneficiary’s home state offers any state tax or other benefits that are only available for investments in such state’s qualified tuition program. Vanguard Marketing Corporation serves as distributor and underwriter for some 529 plans.