The average price of a college education is consistently rising. State schools are consistently less expensive by about 72%, but even an elite school like Harvard offers close to 52% in need-based grants. New parents often search for the best way to start a college savings account shortly after a child is born, hoping to provide tuition without saddling children with impossibly steep student loans.
However, with multiple savings plans available, it can be difficult to determine which option is best, especially when considering the volatility of certain investments, competing interest rates, taxation, inflation, and various other factors. Two popular options are the Roth IRA and a 529 plan. While both are relatively similar, some notable differences set them apart. Having a good understanding of how they work is the key to determining which form of investment is best for you.
529 plans were initially offered back in 1996 and were created specifically to help parents save money for their child’s college tuition. As such, it offers certain tax advantages when used to cover college-related costs. These are available in two different types—529 savings plans and prepaid tuition plans, though the former is far more commonly used.
When parents invest in 529 savings plans, the money can grow tax-free over the next several years. Tax-deferred accounts usually require that taxes be paid upon withdrawal. However, 529 plans provide a unique benefit. Once a child is old enough to go to college, parents can withdraw funds from the account for qualified education expenses without paying any taxes on those funds. Qualified education expenses include tuition, required student activity fees, required textbooks, school supplies, computer and Internet fees, and room and board. Additionally, if you contribute to a 529 plan in your state of residence, you may qualify for state income tax deductions. You could get up to $15,000 with this type of contribution.
If your circumstances change, 529 savings plans allow you to change the beneficiary of said plan to another member of the family. However, the tax exemptions for withdrawals would no longer apply. The only exception to this is situations where your child is awarded a scholarship. You can withdraw an amount equal to that of the scholarship from the 529 saving plan without paying any taxes. The general lack of flexibility within such plans can make these less beneficial in many situations.
Roth IRAs were first introduced in 1997 and were designed as retirement plans. Despite this, they serve as rather efficient vehicles for college savings. As with 529 plans, investments can grow tax-free. Traditionally, earnings in the Roth IRA can then be withdrawn tax-free only if the owner of the account waits until they are 59.5 or older. Otherwise, they must pay taxes and penalties on the withdrawals. One exception to that rule regards college expenses.
The original contribution can be withdrawn without penalties or taxes. In contrast, any earnings you’ve made can be withdrawn penalty-free when used to cover college expenses for yourself, your spouse, or your descendants. However, you’ll still be required to pay taxes on the withdrawal, unlike a 529 plan.
The biggest advantage of a Roth IRA is that it offers a lot of flexibility. If your situation changes and you no longer need to use the money to cover college education costs, you can simply use the funds as a retirement account and enjoy all the tax benefits involved. These accounts also have far more investment options available.
Which Is Best for You?
Surprisingly, only 29% of parents in the U.S. plan to pay for their children’s tuition. If you’re looking for an option that will give you the most benefits for college-related expenses, 529 plans offer much more substantial tax breaks. But if you would prefer to allow yourself more flexibility if your circumstances change, then a Roth IRA will be the far more versatile choice.