There are two tax-smart ways to set aside money for college: 529 plans and Roth IRAs. While 529 plans are designed to pay for education, you can also tap a Roth IRA for college—even though it's intended for retirement.

Key Takeaways

  • 529 savings plans and Roth IRAs are tax-advantaged options to save for college.
  • For 2020 and 2019, you can contribute up to $6,000 a year ($7,000 if you’re age 50 or older) to a Roth IRA. For 529 plans, there is no technical limit set by the IRS.
  • Some families use both options to save for college.

What Is a 529 College Savings Plan?

A 529 plan is a lot like a Roth IRA, but it’s designed for education expenses instead of retirement. Originally, you could a 529 to cover only post-secondary education costs. But it was expanded to include up to $10,000 per beneficiary for K-12 education under the Tax Cuts and Jobs Act.

There are two primary types of 529 plans:

  • Prepaid tuition plans: These allow you to pay in advance for the beneficiary's expenses at designated schools.
  • Savings plans: These are tax-advantaged savings accounts, similar to IRAs.

For this article, we'll focus on 529 savings plans.

19.7

The average number of years it takes someone with a four-year degree to pay back a student loan.

All 529 plans are set up at the state level, but you don’t have to be a resident of a particular state to enroll in its plan. For example, if you live in Florida, it’s perfectly okay to enroll in California’s plan.

If the original beneficiary doesn’t use the money for education, you can change beneficiaries within a fairly wide list of family members, including yourself.

Advantages of 529 College Savings Plans

Contributions aren’t deductible on your federal taxes. However, if you live in one of the more than 30 states that offer state income tax advantages for using that state’s plan, you may get a full or partial tax deduction or credit.

Your money grows tax-free in the account. And you won’t be taxed when you withdraw money from the plan, provided you use it for qualified education expenses.

There are no income or age limits for 529 plans. And the annual contribution limit is $15,000—which, incidentally, is the same limit for the gift-tax exclusion.

Finally, a 529 plan isn’t a complicated investment product to manage. It’s largely based on a “set it and forget it” model where you select a certain track, contribute regularly, and watch the balance grow.

Disadvantages of 529 Plans for College

First, because it’s specifically for education expenses, you have to use the money for the intended purpose or pay the price—literally. Although only the earnings portion is subject to taxes and penalties, you pay normal income tax and a 10% penalty to take the money back.

There are ways to claim an exemption from the 10% penalty, but you’ll still be on the hook for the taxes. If nothing else, you can make yourself the beneficiary and use the funds to further your own education.

Second, the investment options are limited. Offers vary widely among states, and some state 529 plans perform much better than others. If you’re a savvy investor, you may not like the options you’re given. Make sure you also compare fees.

What Is a Roth IRA?

You may know the Roth IRA as a retirement vehicle, but you can also use it to save for college.

Young investors—including teens—can really take advantage of a Roth IRA because they pay taxes now when they’re likely in a low tax bracket. 

You can contribute to a Roth IRA at any age, as long as you have “earned income” (taxable income) and don’t make too much money. Unlike traditional IRAs, there are no required minimum distributions (RMDs) with Roth IRAs during your lifetime. That means you can keep your money in the account if you don’t need it. And when you pass away, your heirs can enjoy years of tax-free growth and income.

Advantages of Roth IRAs for College

Many of the advantages that make a Roth IRA a great way to save for retirement make it an ideal way to save for college, too.

Like the 529, there is no income tax deduction when you contribute to a Roth IRA. Instead, your contributions and earnings grow tax-free. And because you’ve already paid your taxes, you can withdraw contributions at any time, for any reason, tax-free.

Many families use money from a Roth IRA to pay for at least a portion of their children’s college expenses. The real magic of the Roth IRA happens if you waited until later in life to have kids or you’re saving for grandkids.

Once you reach 59½ (and it's been at least five years since you first contributed to a Roth) all of your withdrawals—earnings as well as contributions—are tax-free. That means 100% of your withdrawals can go to college expenses. If you’re not 59½ yet, withdrawals of earnings will be subject to income taxes, but not an early withdrawal penalty, as long as the cash is used for college expenses.

What’s more, any money you don’t end up spending on college can remain in the Roth to fund your own retirement.

Disadvantages of Roth IRAs for College

First, the annual contribution limit is low. For 2019 and 2020, you can contribute $6,000—or $7,000 if you’re age 50 or older. That means that over the course of 18 years, you could add up to $108,000, or $216,000 if you and your spouse both contribute to an IRA.

Generally speaking, both of you would have to contribute the full amount to fund a child’s college education on contributions alone.

Second, unlike some 529 plans, there’s no state income tax deduction for Roth IRAs.

Third, money that’s inside a Roth isn’t counted for financial aid purposes. However, withdrawals are counted, and that can affect your financial aid package. That’s because withdrawals are counted as income, even though the money isn’t taxed.

Finally, by using a retirement account for college savings, you lower the amount of money you can save for your own retirement. If using a Roth to save for college impacts your retirement savings because you bump up against annual contribution limits, it might be better to use the 529.

You Can Use Both Plans to Save for College

It can be difficult to choose between a 529 plan and a Roth IRA. But there’s nothing that says you can’t fund both, provided you’re financially able to do so. This can be a good strategy. You can use the money from the 529 first, and then tap the Roth for any leftover expenses. Whatever money is left in the Roth can stay there for your retirement.