Two popular ways to do so: a 529 plan and a Roth IRA.

Earnings in the account grow tax-free and can be withdrawn tax-free and penalty-free only after you reach retirement age. So what’s the best way to save? Property and Casualty insurance services offered through NerdWallet Insurance Services, Inc.: Licenses, NerdWallet Compare, Inc. NMLS ID# 1617539, NMLS Consumer AccessLicenses and Disclosures, California: California Finance Lender loans arranged pursuant to Department of Financial Protection and Innovation Finance Lenders License #60DBO-74812. But if you use the earnings for qualified education expenses, you'll avoid the 10% penalty, but not the income taxes, provided that the account is at least five years old.

What’s more, any money you don’t end up spending on college can remain in the Roth to fund your own retirement. While it is commonly said that for most people a home purchase is the largest investment they will ever make, a parent’s investment in their child and the child’s future – including college tuition – oftentimes far exceeds the costs and financial complexity of a simple real estate purchase. It may seem out of the ordinary to use a retirement account to save for college, but you can. But if there's no one else in the family who may be college-bound, you're better off saving in a Roth. Keep in mind that this favorable treatment does not apply to 529 plans owned by grandparents or other relatives.

There is no income limit for contributions to a 529 plan and you may contribute to any state's plan, regardless of your actual state of residence. Read more on 529 plan rules here.

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. A mutual fund can have attractive growth potential, but you’ll likely end up paying a hefty tax bill. Computers are also covered if they are a requirement for enrollment. Better Buy: Vanguard Small Cap Growth ETF or iShares Russell 2000 Growth ETF? This is a great option when significant tuition increases are expected between opening your savings plan and your child going to college. Roth IRAs, as well as other retirement accounts are not considered assets when determining a family’s EFC. Individuals of all income levels can enjoy the benefits of a 529 account. Finally, a 529 plan isn’t a complicated investment product to manage.

Fewer Tax Benefits.

For 529 plans, there is no technical limit set by the IRS as long as certain requirements are met. The account holder or his/her authorized representative must direct all investment transactions and choose the investment(s) for the account. In August 2020, the Securities and Exchange Commission (SEC) adjusted their definition of an “accredited investor” for the first time in decades. This may influence which products we write about and where and how the product appears on a page. Here’s why: Withdrawals on earnings are not always tax-free. Investopedia uses cookies to provide you with a great user experience. If you take a non-qualified withdrawal, the earnings portion will be subject to income tax and a 10% penalty. If you’re looking to reduce your gift tax exposure through gifting, you can elect to make a contribution between $15,000 and $75,000 as made over five years. Savings Plans for College: 529 Plans vs. Roth IRAs, 4 Smart 529 Plan Alternatives to Consider.

Copyright 2020 Leaf Group Ltd. / Leaf Group Media, All Rights Reserved. That means you can take out as much as you put in tax-free to pay for college and withdraw the earnings portion tax-free when you turn 59 1/2. A 529 plan is a tax-advantaged account that can be used to pay for qualified education costs, including college, K-12, and apprenticeship programs.

A Roth IRA often provides the exact same tax benefits. Unlike a Roth IRA, every distribution contains an earnings portion and a contribution portion. 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.

Lower EFC means more financial aid. 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. Offers vary widely among states, and some state 529 plans perform much better than others. Instead, your contributions and earnings grow tax-free. The average cost of sending a child to a four-year public university is over $75,000 today, which means if you have a young child you can expect to pay over $150,000 when their time comes.
But it works in reverse for income: Money you withdraw from a Roth IRA does count as income on the FAFSA — yes, even if the IRS doesn't tax it as income. Note that if you're choosing your own investments, it's essential to shift to a more conservative asset allocation as college years gets closer, just as you would when retirement is approaching.

To compare, withdrawals on earnings are tax-free with a 529 plan when you use them for qualifying education expenses. For children who earn scholarships to college, a 529 plan can be used for other educational expenditures with no penalty.

ORIGINAL POST: 01/13/2015; UPDATED 6/9/2019. The rules are extremely complex and also vary by state for 529s, but in a nutshell: You fund both 529s and Roths with after-tax dollars, and the money grows tax-free. A Roth IRA is meant for your retirement, hence the name "individual retirement account." This information may be different than what you see when you visit a financial institution, service provider or specific product’s site. All Rights Reserved 444 Brickell Avenue, Suite 820 Miami, FL 33131 Phone: (585) 286-5426. Distributions from both an education IRA and a 529 plan are tax-free as long as the funds are used to pay for qualified education expenses. 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. Qualified expenses include tuition, room and board, books, fees, uniforms, transportation, tutoring, computers, equipment and supplies. Unlike a Roth IRA… Saving for College: Life Insurance or 529? Roth withdrawals count as income for financial aid purposes and can affect how much aid will be offered. *Resource: “3 Reasons to Use a Roth IRA Over a 529 Plan for Education Savings” Ed Slott Report. Even if you’re not age 59 ½ (or haven’t met the required holding period) at the time education-related expenses need to be paid, you may still be able to take funds out of your Roth IRA tax and penalty free. Contributions and earnings grow tax-free. Here are four times it makes sense. NerdWallet strives to keep its information accurate and up to date. And, since the passage of the SECURE Act in Dec. 2019, you can now pay off $10,000 of college debts each for the beneficiary and the beneficiary's siblings from unused 529 funds. If you find discrepancies with your credit score or information from your credit report, please contact TransUnion® directly. 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. There's no state income tax deduction for Roth contributions. That means you can keep your money in the account if you don’t need it. Roth IRAs give you much more freedom and flexibility on how to invest your funds, whereas 529 plans often have limited options. You won't need the money until the final two years of school. When determining the EFC, only a maximum of 5.64 percent of a parent’s assets will be used to pay for college expenses. The financial aid calculus is tricky, but it boils down to: 529 plan assets count against you, but Roth IRA assets don't. The limit increases to $26,000 for joint filers. In this situation, most parents consider either a 529 Plan or a Roth IRA as the ideal way to save.
In this situation, most parents consider either a 529 Plan or a Roth IRA as the ideal way to save. Many families use money from a Roth IRA to pay for at least a portion of their children’s college expenses. You don’t know if your child will receive a scholarship or decide not to attend college.

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Your Roth IRA contributions are limited to $6,000 a year or $7,000 if you're 50 or older. 529 plans allow for tax-free withdrawals of earnings, while Roth IRAs do not (at least, not until you’re age 59-1/2). It’s your money! Rebecca Lake is a freelance writer and virtual assistant living in the southeast.

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