Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / 529 Plans vs Roth IRAs for College Savings
Transcript
- Lucas: So let's say you have ten thousand dollars a year to put aside for your kid's college. You're pretty sure you don't want to touch it for at least a decade. The obvious move for most families is a 529 plan. But there's another account that's been quietly competing for that same dollar — the Roth IRA. Luna: And I think a lot of people hear 'Roth IRA' and immediately think retirement. But the rules around withdrawals for education are actually surprisingly generous. Lucas: Generous and underused. The IRS lets you withdraw your Roth IRA contributions — that's the money you put in — at any time, for any reason, completely tax-free and penalty-free. No questions asked. And if you're taking that money out for qualified higher education expenses, even the earnings can come out penalty-free. You still owe income tax on the earnings, but no 10 percent penalty. Luna: So for a family that's maxing out their retirement savings already, a 529 is probably the cleaner tool. But for a family that's not sure they can lock up money until college — maybe they want the option to use it for retirement if things change — the Roth starts to look interesting. Lucas: Exactly. The 529 is purpose-built. It's designed to get you to spend it on education, with state tax deductions in about 30 states, tax-free growth, and tax-free withdrawals for qualified expenses. But if your child doesn't go to college, or gets a full scholarship, or you just decide you want the money back — you pay income tax plus a 10 percent penalty on the earnings. The Roth avoids that penalty for education, and there's no penalty on contributions ever. Luna: But there are contribution limits. A Roth IRA is capped at seven thousand a year in 2026, and that's total across all your IRAs. A 529 has much higher limits — often three hundred fifty thousand or more per beneficiary, depending on the state. So if you're saving aggressively, the 529 wins on capacity. Lucas: Right. And the Roth requires earned income. If your kid doesn't have a job, they can't have their own Roth IRA. But you can open a Roth IRA for yourself and earmark it for their education. The key is that the account owner controls the money, so the parent's Roth can be used for the child's college without the child ever having access to it. Luna: Let's talk financial aid. That's where a lot of families get tripped up. How do these accounts show up on the FAFSA? Lucas: Big difference. A 529 plan owned by the parent is counted as a parent asset on the FAFSA. The current formula assesses it at a maximum of 5.64 percent of the value. So a hundred thousand dollars in a 529 reduces aid eligibility by about five thousand six hundred forty dollars. But a Roth IRA owned by a parent is not counted at all on the FAFSA. Zero. It's considered a retirement asset, and retirement assets are excluded. Luna: That's a huge advantage for the Roth in the aid calculation. But wait — if you withdraw money from the Roth for college, does that count as income on next year's FAFSA? Lucas: Only the earnings portion counts as income. The contributions come out tax-free and are not reported as income. So if you withdraw ten thousand dollars and six thousand of that is contributions and four thousand is earnings, only the four thousand shows up as parent income on the FAFSA the following year. And parent income is assessed at a higher rate, between 22 and 47 percent depending on the total. So it's not a free pass, but it's still better than having the asset sit there and get counted every year. Luna: So there's a timing strategy there: take the withdrawals in the early years of college, spread them out, maybe avoid having too much income concentrate in one year. Lucas: Exactly. But there's a bigger catch with the Roth IRA: you can only withdraw contributions without tax or penalty. The earnings are still taxable, even if penalty-free for education. And the total you can withdraw from a Roth for education is limited by your total contributions over time. If you've contributed thirty thousand dollars over ten years, that's the most you can take out without touching earnings. Luna: Which is why a lot of planners say a Roth works best as a supplement, not a primary savings vehicle. Put enough in a 529 to cover maybe half of projected costs, then use the Roth for flexibility on the rest. Lucas: And if today was actually useful to you, the way these stay ad-free is listener support — buy me a coffee dot com slash fexingo. Just a small gesture keeps us independent and focused on the numbers that matter. Luna: Yeah, it really makes a difference. I know a lot of you have told us you appreciate not having ads, and this is how we keep it that way. Lucas: Alright, back to the comparison. Another angle: the state tax deduction. In states like New York, California, or Texas, there's no deduction for 529 contributions. But in states like Illinois, Michigan, or New York — wait, New York does have a deduction up to five thousand dollars for single filers. So if you live in a state with a generous deduction, the 529 gets a built-in return that the Roth can't match. Luna: Right. In Illinois, you can deduct up to ten thousand dollars per year per beneficiary. That's a state income tax savings of about 495 dollars if you're in the 4.95 percent bracket. That's almost 5 percent immediate return on your contribution before any investment growth. Lucas: That's hard to beat. But the Roth has its own tax advantage: distributions in retirement are completely tax-free. If you end up not using the money for education, that Roth dollar is more valuable in retirement than a taxable account dollar. With a 529, if you don't use it for education, you're looking at a penalty. There's a rollover option now — up to thirty-five thousand dollars can be rolled from a 529 to a Roth IRA for the beneficiary — but that's a recent change and it has limits. Luna: The SECURE 2.0 Act, right? Starting in 2024, you can roll over up to thirty-five thousand dollars from a 529 to a Roth IRA for the same beneficiary, but the account has to be at least 15 years old, and the rollover counts against the annual Roth contribution limit. So it's not a free pass, but it does reduce the penalty risk. Lucas: That's a game changer for some families. Let's say you saved aggressively in a 529 and your child gets a full scholarship. You can roll over up to thirty-five thousand dollars into their Roth IRA over multiple years. That gives them a huge head start on retirement savings. The 529 isn't as locked-in as it used to be. Luna: So for a young family just starting out, what's the practical advice? Let's say they have a newborn and can save two hundred dollars a month. Lucas: I'd say start with the 529 if your state offers a tax deduction. Max out that deduction first. Then if you still have savings capacity, consider a Roth IRA for yourself. The Roth gives you flexibility, and you can always use it for education later. If you don't have a state deduction, the Roth might be the better first choice because of the financial aid treatment and the flexibility. Luna: And for families that are already maxing out their 401k and Roth IRA? Then the 529 is a no-brainer. You've already used your retirement tax shelters, so the next best thing is the 529 for education. Lucas: Right. The key is that these accounts aren't mutually exclusive. You can have both. And the optimal mix depends on your income, your state, your risk tolerance, and your confidence that the kid will actually go to college. Luna: One more thing: the Roth IRA has income limits. In 2026, single filers with modified adjusted gross income over about one hundred sixty-five thousand can't contribute directly to a Roth. They'd need to use a backdoor Roth contribution. That adds complexity. 529s have no income limits. Lucas: Good point. High-income families might find the Roth inaccessible or cumbersome. The backdoor Roth is simple enough if you don't have any existing traditional IRA balances, but it's an extra step. The 529 is straightforward — anyone can open one regardless of income. Luna: So let's sum it up. If you want maximum tax benefit for education and you're confident the money will be used for school, go 529. If you want flexibility and better financial aid treatment, and you're willing to accept less capacity and income limits, consider the Roth. Lucas: And if you're not sure, a hybrid approach: fund a Roth IRA first because contributions can always come out tax-free, and then once you've built a solid retirement base, add a 529 for the dedicated education savings. That way you don't over-commit to either goal. Luna: It's a matter of knowing your own numbers and your own priorities. There's no one-size-fits-all answer, but the trade-offs are pretty clear once you map them out. Lucas: Exactly. And that's the kind of decision that can save a family thousands of dollars over the life of a college savings plan. Worth running the numbers for your own situation.