With college costs so high, it's never too early to start saving for your kid's college education. Both Roth IRAs and 529 plans offer tax-sheltered growth and the potential for tax-free distributions, but only 529 plans are specifically designed to help you save for college. Roth IRAs, on the other hand, were created to save for retirement.
529 Plan Advantages
If you're hoping to a save a lot of money for college, 529 plans have the advantage hands down. As of 2012, you're limited to contributing only $5,000 per year to a Roth IRA. With a 529 plan, you can contribute as much as is needed to provide for the beneficiary's college education, which could be well into the six figures. In addition, if you use the money for qualified college expenses, you get all the money out tax-free, including earnings. Qualified college expenses include tuition, fees, supplies and -- if enrolled half-time or more -- room and board.
529 Plan Disadvantages
If you end up not using the money for qualified college expenses, you'll have to pay taxes on the earnings and you'll potentially owe a penalty for non-qualified withdrawals. For example, if your daughter earns a full-ride scholarship and you withdraw money form a 529 for something other than education expenses, you'll avoid the 10 percent penalty on qualified distributions, but you'll still owe income taxes on all of the earnings. Also, any expenses you pay from the 529 plan can't be used in calculating a tax credit for college costs, such as the American opportunity credit.
Roth IRA Advantages
An advantage that Roth IRAs do have over 529 plans is investment flexibility. With a Roth IRA, you can pick any financial institution and a range of investments, including mutual funds, individual stocks and bonds, and certificates of deposit. In addition, the IRS doesn't limit how often you can change your investments. With a 529 plan, you have to pick from the investments offered by state-approved financial institutions and you can only change your investments once per year.
In addition, you can get your contributions out tax-free for any reason. If you end up not needing the money for college, such as if your child gets a full scholarship, you can leave the money in the Roth IRA and take tax-free distributions -- including your earnings -- at retirement.
Roth IRA Disadvantages
After you've taken out your contributions, your earnings are taxed unless you can take a qualified distribution. Roth IRAs do offer an early withdrawal exception to the 10 percent penalty for college expenses paid for a child, but you'll still owe income taxes. For example, say you contribute $40,000 by the time your child is ready to go to college and the account is worth $70,000. If you use the entire $70,000 for college, you'll get the first $40,000 tax-free, but you'll pay taxes on the last $30,000. With a 529 plan, the entire amount would come out tax-free.
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