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College Savings: Roth IRA, 529 Plan, or Coverdell?

A commonly-given piece of financial advice is to use a Roth IRA to save for your children’s college. For the most part, however, this isn’t a great idea.

Yes, it’s true that money inside a Roth IRA grows tax-deferred, and yes it’s true that money withdrawn from a Roth IRA will be free from the 10% penalty if it’s used for qualified higher education expenses. What many investors overlook, however, is that unless you’re 59½, disabled, or dead, withdrawals of earnings from a Roth IRA are still taxed as ordinary income–even if they’re used for qualified education expenses.

This means that the earnings will be taxed according to your tax bracket at the time of the withdrawal. In contrast, if you had simply invested in tax-efficient investments (like ETFs) in a taxable account, both the dividends and long-term capital gains would be taxed at a maximum rate of 15% rather than at your ordinary income tax rate.

A Better Method: 529 Plans

In contrast, money withdrawn from a 529 plan comes out free from taxes (regardless of your age) as long as it is used to pay for qualifying higher education expenses. Also, in many states, contributions made to a 529 plan qualify you for a state tax deduction. Deductible on the way in and tax-free on the way out? Not bad!

What If My Child Doesn’t Attend College?

Many people worry about the risk of setting up a 529 plan for their child, only to see that the child doesn’t end up attending college. In reality, this risk is fairly minimal. Anyone can be named as the beneficiary, and you can change the beneficiary at any time. So if your first child doesn’t attend college, you could use the 529 to:

  • Pay for the education of your other children,
  • Pay for your own further education, or
  • Pay for college for a niece or nephew.

Basically, as long as somebody you know ends up attending college, you’ll be able to make use of the 529 plan.

Coverdell Education Savings Accounts

A third college savings option is to fund a Coverdell education savings account. Coverdell accounts work much like 529 accounts: Contributions are not deductible, but distributions are tax free as long as they’re used for qualifying education expenses. Also, like 529 accounts, anybody can be named as the beneficiary, and the beneficiary can be changed at any time.

The primary differences between 529 accounts and Coverdell accounts are that:

  • Coverdell accounts can be used for grade school or high school education expenses,
  • Contributions to a Coverdell account are limited to $2,000 per year (In a 529 plan, the limit is set by the state–usually far above $2,000 per year.),
  • Contributions to a Coverdell do not qualify for a state income tax deduction, and
  • You can invest the money in a Coverdell account in any way you choose.

So Which Option Is Best?

For the reasons mentioned above, I generally don’t think that a Roth IRA is ideal for saving for college expenses. Whether a Coverdell or a 529 is more suitable depends upon whether 529 contributions are deductible in your state and upon whether it’s more important to you to be able to:

  • Use money in the account to pay for schooling other than college, or
  • Contribute more than $2,000 to the account each year.

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  1. For your readers…are the three viewed differently or the same from a financial aid viewpoint?

  2. EoW: My understanding is that all three are viewed as assets of the account owner, not the beneficiary. (And in most cases, the parent will be the owner of all three accounts.)

    If anybody has information otherwise, please share! I’m admittedly not very knowledgeable about the federal financial aid formula.

  3. Good find. Thank you for sharing.

    For any readers who just want the answer rather than reading the article:

    Coverdell accounts and 529 plans count as assets of the parent (presuming the parent is the owner). Retirement accounts are specifically excluded from the calculation. So at least that’s one (minor) point in favor of the Roth!

  4. I like the idea of a 529 plan. But I like plans from states that are more flexible, and will let you go wherever. Right now, Ohio’s plan is offering free money if you open a 529 account. Also, it’s a good idea to check the investment options. Some plans have mutual funds with high fees, while others offer low-cost index fund choices.

  5. I disagree with the notion that a Roth IRA is not suited for college savings for tax reasons. I am someone who puts $2500 a year into a Roth, and has the choice to put an additional $200 a month either in the Roth or into a 529 plan, and I go with the Roth. After 18 years, I will be able to withdraw $90K of contributions from the Roth tax free and without affecting financial aid. If I had used the 529 plan and made 9% a year, I would have $100K sheltered. If I needed to withdraw $100K from the Roth I would pay taxes on an extra $10K, or about $2500 a year. In the 15% bracket that is only $375 a year. However, since the $100K 529 counts as a parental asset, it would reduce financial aid eligibility by about $5500 each year. Combine this with the fact that the Roth can be used either for retirement or college and I don’t see the advantage of 529 accounts unless you are already maxing out the 401k and Roths.

    To me, I would not be satisfied saving $200 a month for 18 years so I can pay for college for a nephew. I would much rather have put that money in my retirement and still have the choice of whether to withdraw the contributions (not be forced into it because of tax consequences).

  6. @ Dave – I don’t think the claim was that Roth IRA is not suited for college savings. He said it was not ideal.

    There are lots of ways to save and pay for college, the best vehicle or combination of vehicles will vary from case to case.

    Mike left out the traditional IRA which can be a useful tool for paying for college, especially for parents in a position to legitimately employ their children. Shifting income to fund the kid’s IRA with a tax deduction can save taxes and can improve financial aid.

  7. Mike, you’ve only got your point half right. Retirement accounts are excluded but distributions are treated as income. So it might help you in your freshman year but then could significantly hurt you going forward if you plan to withdraw from these accounts. Also doing a Roth IRA conversions while your kids are in college is going to boost your income significantly which could have a huge impact on financial aid.

    So for Dave, that $90k or $100k that you are planning to withdraw from your Roth is going to be counted as income after you withdraw it. Have you looked at how that is going to affect your financial aid?

  8. @EOW, couldn’t you just withdraw all the Roth contributions the year before you apply for financial aid?

  9. Roth distributions are only income to the extent that they exceed contributions. However, once distributed, they will be counted and assessed as assets in financial aid calculations. If you withdraw all your Roth contributions before you apply for financial aid, you will likely increase your expected family contribution thereby decreasing your potential aid.

    When you combine resources such as 529/CESA, IRA distributions, tax credits, current income, financial aid, etc., you can plan when and from where to pay college expenses in an efficient way. The strategy may not look the same for each year.

    The first year aid package may also set the stage for future years at the same school (i.e. gift vs. loan aid allocations).

  10. Dylan, you are right about Roth distributions from an IRS/tax standpoint. From a financial aid standpoint (i.e. filling out the forms) they actually add distributions from a retirement account to your income. If you withdrew the money lumpsum it would be sitting in some account and be treated as an asset.
    There are definitely strategies of combining resources to help increase your financial aid. How about you leave the money in the Roth IRA to continue to grow. Your kid takes out loans and you take distributions from your Roth IRA (of contributions) to pay either the loan payments or some or all of the loan?

  11. Another advantage of a Roth IRA vs. a 529 plan is the fund offerings. I’m in Missouri, and our 529 plan has expense ratios of 0.62% for each fund portfolio (MO uses Vanguard and American Century). If you buy one of these funds directly from Vanguard through a Roth IRA, your expense ratio is only 0.21%.

    The 529 plans severely restrict your fund choices as well.

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