I received a tweet from Shawn B. who says, “My wife and I are having a baby soon and we want to save for his education. Is an IRA or a 529 plan better for college savings?”
Shawn, congratulations on your new arrival and thanks for your question!
No matter if you’re saving money to pay for college for yourself or for a child, it’s important to use the right account so you get as many benefits as possible. In this post I’ll cover saving for college with an IRA and a 529 plan and recommend the best option to get the most for your money.
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What Is an IRA?
To answer Shawn’s question about using an IRA or a 529 plan for college savings, let’s start with a quick review of the two main types of IRAs and who can have them.
IRA is short for Individual Retirement Arrangement, which is a type of tax-advantaged account that helps you save more for the future than you could using a regular, taxable brokerage account. You choose investments from a menu of options and your account value fluctuates based on their performance.
With a traditional IRA contributions are tax-deductible, which means you don’t have to pay taxes on them in the current year. For example, if you earn $75,000 and contribute $5,000 to a traditional IRA, you only have to pay tax on $70,000 of income.
Taxes on your contributions and their earnings are deferred in a traditional IRA until you make withdrawals at some future date. So it’s a great option when you need a tax break or believe that your tax rate is higher today than it’s likely to be in retirement.
With a Roth IRA contributions are not tax-deductible, which means you do have to pay tax upfront. Using the same example, if you earn $75,000 and contribute $5,000 to a Roth IRA, you have to pay tax on $75,000.
However, what’s so powerful about a Roth is that both your contributions and earnings can be withdrawn completely tax free when you retire. You avoid paying tax on years or decades of growth in the account—that’s a fantastic benefit!
A Roth is a smart option if you believe that your tax rate is lower today than it’s likely to be in the future. That’s probably the case if you’re just starting your career and are earning less now than you will down the road. The idea is that paying tax at a lower rate now, instead of at a potentially higher rate in the future, saves money.
See also: 6 FAQs About Roth Retirement Accounts
Who Can Have an IRA?
Many parents mistakenly believe that they can open up an IRA in a child's name and begin funding it.
Before you can contribute to either a traditional or a Roth IRA there’s an important requirement: you typically must have earned income, such as a salary, wages, tips, bonuses, commissions, or self-employment income. The only exception is a spousal IRA, which allows you to have a retirement account if you're married and file taxes jointly, but don't earn income.
And with a Roth, you become ineligible to make contributions when you earn too much, which I’ll explain in just a moment.
An IRA can’t be owned jointly or owned for someone else. Minors can have their own traditional or Roth IRA once they earn money. So children can start contributing to an IRA as soon as they get their first part-time job or have self-employment income.
Many parents mistakenly believe that they can open up an IRA in a child’s name and begin funding it. If you have a non-working child, the only option is to fund your own IRA and then take withdrawals from it later on to pay for his or her college expenses.
For 2016, you can contribute an amount equal to your taxable compensation up to $5,500 or up to $6,500 if you’re age 50 or older.
See also: What Are the Roth IRA Rules for Married Couples?
What Is the Roth IRA Income Limit?
Because the tax benefits are so good with a Roth IRA, the amount you can contribute is reduced or eliminated when your income reaches certain limits. For 2016, single taxpayers who earn more than $132,000 are shut out. And the cutoff for married people who file a joint tax return is $194,000.
If you contributed to a Roth IRA in the past but now make too much money to be eligible, congratulations! But don’t let that stop you from saving for retirement—you can open up and contribute money to a traditional IRA instead.
As the cost of living increases, the IRS periodically increases the Roth IRA income threshold. So if your income falls below the Roth cutoff in the future, you can start making contributions again to the same account.
You may be wondering if you can have an IRA and contribute to a retirement plan at work, such as a 401k or 403b. The answer is yes. However, if you or your spouse have a retirement plan at work, the tax deduction for your traditional IRA may be reduced or eliminated, depending on how much you earn.
Remember that you’re never required to make a contribution to an IRA. They stay open indefinitely with no penalty even if you don’t fund them.
See also: A Blueprint to Organize Your Personal Finances
Rules for Taking Withdrawals from an IRA
You can take distributions from an IRA at any time and for any reason; however, withdrawals may be taxable and may also be subject to an additional 10% early withdrawal penalty if you’re younger the official retirement age of 59½.
Now that you understand the basics of traditional and Roth IRAs, let’s talk about the rules for taking money out of them. You can take distributions from an IRA at any time and for any reason; however, withdrawals may be taxable and may also be subject to an additional 10% early withdrawal penalty if you’re younger the official retirement age of 59½.
The good news is that there are exceptions to the 10% penalty and paying for higher education for you, your spouse, your children, or grandchildren is one of them!
But what about taxes? Well, that depends on which type of IRA you have.
With a traditional IRA you don’t pay tax upfront on contributions. So taking a withdrawal for any reason does trigger income tax. Uncle Sam makes sure you pay your share. But you get to skip the additional 10% penalty if you use the money for education expenses.
With a Roth IRA you pay tax upfront, and therefore never have to pay it again. As long as you don’t take out any of your earnings or growth in the account (which haven’t been previously taxed), you can take an early withdrawal from a Roth IRA to pay for college that’s penalty free.
For example, let’s say you have $10,000 in your Roth IRA that’s made up of $9,000 of your original contributions and $1,000 in growth. Taking out the full amount to pay for a child’s education means that you’d owe tax (but not not a 10% penalty) on $1,000.
An additional factor to consider is that taxable distributions from either type of IRA get added to your income, which could affect the next year's financial aid eligibility for your child.
See also: Your Guide to the Roth IRA
What Is a 529 Plan?
As you can see, if you plan on using funds from an IRA to pay for college, having a Roth gives you a leg up over a traditional account because you can pay less or no income tax on withdrawals. However, as I previously mentioned, if your income exceeds the allowable limit, you may be shut out of a Roth IRA.
Let’s talk about how an IRA stacks up against another great account commonly used for education expenses—a 529 college savings plan. These accounts allow you to save for college in two ways: using a prepaid plan or a savings plan.
With a 529 prepaid plan you pay for tuition at a state school ahead of time. That means you get tomorrow’s tuition at today’s prices. Since the cost of college continues to skyrocket every year, this prepayment strategy can save a lot of money.
But what if you prepay at one school and your child wants to go to a different one? Funds in a prepaid plan may be withdrawn so you can use them at an out-of-state school or a private college. However, you may not get the full value out of the plan because you’ll generally have to make up the tuition difference.
With a 529 savings plan, you invest contributions in a tax-deferred account. This is similar to a retirement account, where you choose investments from a menu of options.
Savings plans are offered by states, not schools, and they can be used at any accredited school in the country, and even at some foreign institutions. For instance, you could live in New York, participate in a Florida 529 saving plan, and use the money to pay for a school in California.
Most states offer at least one 529 plan; however, the fees and benefits, such as the maximum contribution limit and investment options, vary. Unlike an IRA, some 529 plans allow you to save over a quarter million dollars with no annual caps. So do your homework and compare plans across the country using a site like Savingforcollege.com.
As long as the funds in a 529 plan are used to pay for qualified education expenses, such as tuition and room and board, the earnings in the account are not subject to federal or, in most cases, state tax.
As long as the funds in a 529 plan are used to pay for qualified education expenses, such as tuition and room and board, the earnings in the account are not subject to federal or, in most cases, state tax. Plus, some states offer tax deductions or credits for residents who choose in-state plans.
You can even have both a 529 prepaid plan and a savings plan. The prepaid account would pay for tuition and the savings plan could be for other expenses, such as room and board, books, supplies, and computer equipment.
See also: Are You Making Investing Too Complicated?
IRA or 529 Plan—Which is Better for College Savings?
Due to all the benefits that come with a 529 plan, it gets my vote for the best account to save for college. Distributions get favorable treatment because unlike with an IRA, they're not a factor in the calculation for the following year's financial aid eligibility. This is the case no matter if a 529 plan is owned by the student or a parent.
The only drawback is that if you use 529 funds for anything other than qualified education expenses, those distributions will be subject to income tax, plus a 10% penalty. So never contribute more to a 529 than you believe your child will need for the total of his or her education expenses.
To sign up for a 529 you can go directly to the plan manager or use a financial advisor. Using an advisor may cost a little more, but may be worth it if you’re new to investing.
Free Resource: Retirement Account Comparison Chart (PDF download)—get the rules for the most popular retirement accounts
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