As a new school year begins, smart parents and grandparents of teens and pre-teens are thinking beyond high school. Specifically, they’re wondering about the best way to save for future college expenses.
Although there are several ways to do it, the Roth Child IRA and the 529 plan are the two most popular methods to save for college. Each has its advantages and disadvantages. Is one better than the other?
Why is a 529 plan better than a Roth Child IRA?
Conventional wisdom looks to the 529 plan for the purposes of saving for college. This is the only reason why they exist. They were built to amass significant savings quickly.
“The 529 plan is specifically designed for education savings,” says Rita Mkrtchyan, Senior Attorney at Oak View Law Group in Burbank, California. “Technically, with 529s you can save substantial funds in a short period, with the caveat that once you reach a limit, you cannot contribute more. Roth Child IRAs do not have an upper limit. Roth Child IRA contributions, like other IRAs, are limited to a maximum of $6,000 per year for those under 50 years of age. In contrast, 529 plans do not require contributions to be offset by earned income, and there is no statutory annual cap on contributions. There is, however, a practical limit of $15,000 annual gift exclusion per person.”
Compared to the Roth Child IRA, aside from standard gifting limits, the 529 plan does not have any other obstacles.
“The Roth Child IRA is not a good tool to save for college expenses because the IRS requires the child to have earned income in order to establish a Roth Child IRA in his or her name,” says Glen Goland, Senior Wealth Strategist/Senior Investment Advisor at Arnerich Massena in Portland, Oregon. “The Fair Labor Standards Act sets 14 as the minimum age for most non-agricultural work in the United States. If a child begins work at 14 and maximum contributions are made to his or her Roth IRA each year, the Roth will likely have $20-30,000 in it when the child reaches 18, hardly enough to cover college costs. The 529 offers the chance to invest more money for longer time periods with the same tax-free growth.”
Keep in mind, it is possible for minor children as young as infants to earn income and open a Child IRA. This can have a critical impact on your decision as to the value of using a Roth Child IRA or a 529 plan for college savings.
Still, the 529 plan may offer other advantages, depending on the state in which you live.
“There is no tax deduction for making contributions into a Roth IRA while some states offer deductions for 529 contributions,” says Matt Gray, Founder of AnthroFi Wealth Group in Denver.
Is a Roth Child IRA a good idea for a college student?
The biggest advantage of a 529 plan—being designed specifically as a college savings vehicle—is also its biggest disadvantage. It lacks elasticity in the event plans change.
“People gravitate towards this idea of using a Roth Child IRA for a few reasons,” says Derek Amey, Partner and Advisor at StrategicPoint Investment Advisors in Providence. “One is the flexibility it provides should the child not attend college or if the child receives a large scholarship. Parents always fear having money locked up in a 529 they can’t end up using. The Roth Child IRA eliminates a portion of that fear since contributions to a Roth can be pulled out tax and penalty-free.”
A Child Roth IRA offers an avenue to attain many different financial goals. Unlike the 529 plan, it’s not limited to just one.
“A 529 plan is strictly for education-related needs, and the risk of overfunding is worth acknowledging,” says Richard Roberto, Financial Advisor at Fort Pitt Capital Group in Pittsburgh. “Whereas a Child Roth IRA is geared towards retirement but has exemptions from the penalty that allow it to be used for certain common expenses (first-time home purchase, college expenses, and birth or adoption expenses).”
Another advantage (or disadvantage, depending on your point of view) Roth Child IRAs offer is the ability to adopt more comprehensive investment strategies. Amey says, “529 Plans were built with simplicity in mind, and for some sophisticated investors, they find the investment options available in the 529 to be too limited.”
“Roth IRAs have a wider range of investment options compared to a 529 plan,” says Nathaniel Donohue, Partner & Advisor in Consilio Wealth Advisors in Scottsdale, Arizona. “Roth IRAs can often purchase any security from any provider—stock, ETF, mutual fund, etc. 529 plans, however, are often limited based on the plan provider.”
Can a Roth Child IRA affect a child’s eligibility for college financial aid?
Perhaps the most overlooked advantage of a Roth Child IRA comes when it’s time to determine the child’s financial aid package. “Roth assets typically get better treatment on financial aid packages than 529 assets,” says Matthew Newman, Vice President of Client Services & Senior Financial Advisor at High Probability Advisors, LLC in Buffalo.
Currently, the FAFSA form (the form you complete that allows the college to assess your need for financial aid) doesn’t include retirement assets for either the parent or the child.
“A Roth Child IRA can be a better vehicle to save for college than a 529 plan because retirement accounts like Roth Child IRAs are not considered an asset for financial aid purposes, providing a more favorable outcome for financial based support,” says Ryan McKeown, Senior Vice President Financial Advisor at Wealth Enhancement Group in Mankato, Minnesota.
Is it a good idea to open a Roth IRA for a child?
There’s no reason you can’t open up both a Roth Child IRA and a 529 plan. Think of it as diversifying your assets in the same way you might have a mix of both traditional tax-deferred retirement savings accounts and after-tax Roth retirement savings accounts.
Since the Roth Child IRA has the same contribution limits and restrictions as any other IRA, it might make sense to max out that contribution first, then place the remaining available funds into a 529 plan. This will reduce your risk of a “change in plans” regarding college while also allowing you to maximize your college savings.
“A Roth Child IRA isn’t necessarily a better vehicle to save for college than a 529 plan, but it is different and does have some advantages,” says Jason Grantz, Managing Director, Institutional Retirement Consulting at Integrated Pension Services in Highland Park, New Jersey. “Specifically, in the Roth, your money can be purposed for anything, not solely educational expenses, so you have a bit more flexibility to account for a scenario where your child doesn’t need the funds for college expenses for one reason or another. Also, the money contributed to a Roth can be taken out penalty and tax free, whereas 529 plans have lots of rules on how the money is used and if not followed come with taxation and penalties.”
Remember one thing as you review your possibilities: this is a dynamic field. Government laws, regulations, and policies are in a constant state of flux. What works today may not work tomorrow.
Given this, if you see any major changes in the Roth Child IRA or 529 plan environment that occur after the publication date of this article, please share them in the comment section below because that will ensure this article stays current. (And future readers will think more highly of you, too!)