Best Ways to Save for College, Pt. 5: 529 Plan vs. Roth IRA vs. 401k

When saving for college, some folks get creative. If you’re already saving in a retirement account, why not simply use some of that retirement savings to pay for college? After all, these are tax advantaged accounts and – even though they aren’t designed for education – there are education exceptions on the penalties. Retirement accounts are equally useful for saving for college, right?

Wrong.

Despite educational exceptions, retirement accounts usually are not a smart choice for college savings because of tax consequences, financial aid impact, and other restrictions. Instead, consider a 529 College Savings Plan. These accounts have similar tax benefits to a Roth IRA (specifically, tax-free growth and tax-free withdrawals for higher education), but 529s are specifically designed for higher education.

Today, we’ll compare the pros and cons of 529 College Savings Plans compared to two common retirement plans – Roth IRAs and 401ks – as a way to save for college.

529 College Savings Plan

The 529 is the only one of these accounts that is designed specifically to help you save for college expenses. It provides tax-free growth and tax-free withdrawals of the money that you contribute (principal) and the investment growth, as long as those dollars are used for education expenses. So put simply, you contribute after-tax money and then watch it grow until you need to pull it out for college. When you do pull it out, you won’t pay any taxes.

Pros

  • Best Tax Advantage: Tax-free withdrawals of both principal and earnings for education expenses.
  • High Contribution Limits: Can contribute up to $14,000 each year without exceeding the limits of the annual gift tax exclusion, per child and per parent. That means married couples can contribute up to $28,000 per year, per child. Plus, you can “superfund” with 5 years’ worth of contributions at once.
  • No Income Limits: Anyone can contribute regardless of income.
  • Minimal Impact on Financial Aid: Considered assets of the parent, which reduces the impact on the amount of federal financial aid granted.

Cons

  • Penalty: 10% penalty for investment gains not spent on qualified higher educational expenses.
  • Investment Options: You can only invest in the fund options offered by that specific plan.

Roth IRA

This is an Individual Retirement Account (IRA), so it is designed specifically for retirement. (Originally proposed to Congress by Senator William Roth, in case you were curious about the name). Similar to the 529 plan, you put in after-tax money and then watch it grow until you’re allowed to pull it out tax-free. However, for a Roth IRA, that is not until age 59 ½. While a special exception allows you to pull out the money early for qualified educational expenses without paying the typical 10% penalty, you still need to pay taxes on the investment gains. Plus, withdrawals may be counted as income for financial aid.

Pros

  • Investment Options: You can choose your own investment options, and do not have to rely on the fund offerings inside a plan.

Cons

  • Hurts Financial Aid: While retirement account balances are not reported as assets on FAFSA and won’t hurt your first year, this strategy will still negatively affect aid. If you pull money out to pay for college, that will count as income for the following year.
  • Not Tax Friendly: Distributions of investment gains would be taxed as ordinary income Robbing Your Retirement: Parents that pull from their own retirement savings make it much more difficult to be prepared for a happy retirement.
  • Low Savings Cap: Can only contribute $5,500 per year, or $6,500 if over the age of 50. It is only this amount that can be pulled out for college expenses without ordinary income tax.
  • Income Phase Out: Not eligible to contribute the maximum if your modified adjusted gross income is more than $118,000 ($186,000 for a married couple).

401k

A 401k, named after the section of the Internal Revenue Code that outlines the rules around the accounts, is one of the most common savings tools used today. This is because it brings your employer into the efforts to incentivize good savings habits. In a 401k, you contribute a percentage of your salary pre-tax, and watch the money grow tax-free. However, when it comes time to pull out the money in retirement (59 ½), the money is taxed as ordinary income. While early withdrawals for qualified education expenses do not trigger the typical 10% penalty, you will need to pay taxes on any distributions and, usually, count distributions as income for financial aid purposes.

Pros

  • High Savings Cap: Can contribute up to $18,000 per year, before employer matching.
  • No Income Limits: Anyone can contribute regardless of income

Cons

  • Hurts Financial Aid: While retirement account balances are not reported as assets on FAFSA and won’t hurt your first year, this strategy will still negatively affect aid. If you pull money out to pay for college, that will count as income for the following year.
  • Not Tax Friendly: Distributions would be taxed as ordinary income
  • Robbing Your Retirement: Parents that pull from their own retirement savings make it much more difficult to be prepared for a happy retirement.
  • Investment Options: Typically, you can only invest in the fund options offered by that specific plan.

All of these accounts offer great ways to help save for the future. However, the only one specifically designed to save for the high cost of college is the 529 College Savings Plan. While some situations may call for the utilization of a Roth IRA or 401k to pay for college, a 529 is typically the best option for someone who is creating a long-term college savings plan.

This stuff can be confusing and complicated, but opening your 529 plan and getting a jump start on saving for college doesn’t have to be! CollegeBacker is an SEC-registered investment adviser that makes the process as seamless and clear as possible. We'd love to help you navigate the complex world of college savings.

This is the last of a 5-part series comparing options to save for college.