Should You Open a Roth IRA or a 529 Savings Plan?

Roth IRAs and 529 savings plans are great for saving for college—both are taxed upfront, allowing you to withdraw the investment after it’s grown much larger due to compound interest, without getting hit with a huge IRS bill. But which one is better? Like most choices involving your portfolio, their are trade-offs to each, as Roth IRAs offer more flexibility on how the money can be spent, while 529s have higher contribution limits that can maximize savings. Here are some other factors to consider.

The pros and cons of Roth IRAs

Roth IRAs were created for retirement savings, but unlike other retirement accounts like 401(k)s, you’re taxed upfront on your contributions, which means you don’t get taxed later when the total investment is withdrawn. The only catch is that you have to wait until the age of 59½ before you can cash out these funds, which can be used for anything you please (in contrast to 529 savings plans, which charge penalties if you don’t use them for educational spending). On the other hand, you can withdraw money you have contributed (i.e., that you’ve paid in—not including any gains on your investments) at any time, free of taxes and penalties, without waiting for the age of 59½.

Pros of Roth IRAs

• Your contributions (not earnings) can be withdrawn at any time without penalties or taxes.
• Once you reach the age of 59½, all of the money can be withdrawn without taxes or penalties, provided the account has been open at least 5 years (otherwise you may owe income taxes on the earnings).
• There’s no 10% penalty for early withdrawal of all your earnings if the money is spent on qualified education expenses, although you will still have to pay income taxes on it.
• If you don’t need all the money for education, the rest can be used for retirement.

Cons of Roth IRAs

• You’ll likely owe income taxes and a 10% penalty on early withdrawals of your earnings, before the age of 59½ (although as noted above, the additional 10% penalty is waived if you use the money for qualified educational expenses). Even after that age, you may owe taxes and fees if the account hasn’t been open for at least 5 years when you make a withdrawal.
• There are income limits, and the amount you can contribute will phase out if you make more than $125,000 for single filers, or $198,000 for joint filers (you’ll be entirely ineligible to contribute if you make more than $140,000 and $208,000, respectively).
• The tax implications when you’re applying for student aid aren’t favorable, as withdrawals count as income for financial aid purposes, which may negatively affect how much aid will be offered.
• Unlike 529 savings plans, Roth IRA contributions cannot be deducted on your state taxes.
• The annual contribution is low compared 529s; you can only contribute up to $6,000 ($7,000 if you’re 50 or older) in 2021.

The pros and cons of 529 savings plans

A 529 plan is specifically designed as a education savings fund, and is therefore limited to qualified educational expenses like textbooks and tuition (unless you want to pay taxes and a 10% penalty). Unlike an Roth IRA, you don’t have to wait until you’re nearly 60 to make withdrawals.

Pros of 529 savings plans

• There are no income or age limits for withdrawals.
• There are no taxes on withdrawals used for qualified education expenses.
• Contributions to your 529 might be tax deductible at the state level.
• There are virtually no limits to the contributions you can make in any one year, although there might be a lifetime cap, depending on your state (usually around $500,000).
• You can switch or transfer beneficiaries.

Cons of 529 savings plans

• Less flexibility—you have to use the money for the intended purposes or pay a penalty to get it back.
• The investment options tend to be more limited than Roth IRAs.
• Plans are tied to one single beneficiary at a time, which means you have to set up a separate account if you want to save for more than one child.

Which college investment plan should you choose?

When choosing between a Roth IRA and a 529 savings plan, the best option will depend on what’s important to you: flexibility in how you can spend your investment, or flexibility in when you can spend it. 529s allow you to access tax-free money at a much younger age, but there’s a risk of being taxed and penalized if your plans for school fall through, which isn’t the case with a Roth IRA. There are also tax and income considerations to consider, as the contribution limits for Roth IRAs might not meet your specific needs.