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What's the best way to save for a child's education? We compare three options--a 529 Plan, a Roth IRA, and a taxable account.
Is it better to save for a child’s college education with a 529 plan or a Roth IRA? That’s the question that Dan, a listener to the weekly Dough Roller Money Podcast asked. Here’s Dan’s email:

“I was wondering if I could get your thoughts on something I heard today on another financial podcast (Clark Howard)…hey I have to listen to something in between DR episodes 😉

A caller asked the question of whether it would be better to pay for college out of a Roth instead of a 529 plan. Clark said it is controversial, but it is a strategy he endorses.

Basically the thought is that you should *fully* fund both a 401k and a Roth before saving in a 529 plan because you can withdraw the contribution from a Roth to use towards college.

It also has the added benefit of not requiring you to use the money for education if your children do not go to college or need all of the money.

I live in Maryland which has one of the more highly rated 529s and, in addition, has a tax deduction for contributing (“Each account holder can deduct up to $2,500 of contributions each year from Maryland income per beneficiary—$5,000 for two, $7,500 for three, etc.”)

Do you subscribe to this theory as well? Does this tax benefit tip the scales back in favor of a 529?

Would love to hear your thoughts… Keep up the good work.
(oh and let me know if you have any luck with those Google Inbox invites. There are more where those came from)”

Dan’s question is one I faced as my wife and I saved for our son and daughter’s education. We’ll look at the numbers below, but there are three key takeways in response to his question:

  1. The 529 is by far the best way to save for college and could now be used for private K-12 tuition, making it more flexible
  2. There is a risk your child won’t go to college, but there are some ways to deal with this
  3. Beyond a 529, a taxable account is probably better than a Roth IRA for saving for college

Like most personal finance decisions, there are pros and cons to any approach you take to saving for a child’s education. We’ll look at those in detail. But first, let’s make sure we understand the 529 plan.

529 Plan Refresher

We’ve covered 529 plans in detail. In a nutshell–

  • Contributions are after-tax at the federal level.
  • Contributions may be deductible on your state tax return.
  • Money grows free from federal taxes if used for qualifying educational expenses.
  • Most states also allow money to grow free from state taxes, though some charge taxes on gains from out-of-state accounts.
  • The money can now be used for both qualified higher education expenses and up to $10,000 per year in private K-12 tuition.

College Savings Examples

With these basics in hand, let’s look at how much we’d have for a child’s education based on which type of account we used. For these examples we’ll assume the following:

  • Save $5,000 a year for 18 years.
  • Earn a 7% annual return.
  • 25% marginal federal tax rate.

In addition, we will ignore the state tax deduction available to some. It’s of course an important feature for those who live in a state that offers a deduction. And it’s particularly worth paying attention to if you’re considering using the funds for K-12 expenses, as not all states will count these expenses as qualified.

Now let’s look at the numbers.

529 Plan

With a 529 Plan our total contributions are $90,000 ($5,000 x 18 years). At a 7% return, the ending balance is just shy of $170,000 ($169,995.16 to be exact). Assuming the funds are used for qualifying educational expenses, there would be no tax due on the $79,995.16 in gains.

Total Available for Education:  $169,995.16

Roth IRA

With the same contributions and returns, the ending balance before taxes is the same–$169,995.16. With a Roth IRA, you can withdraw the contributions at any time and for any reason, without taxes or penalties. As a result, you can use $90,000 from the Roth IRA for education.

You could also withdraw the $79,995.16 in earnings for educational expenses without paying the 10% penalty. This assumes you aren’t otherwise eligible–e.g., those 59 1/2 or older–to take distributions from a Roth IRA without penalty or taxes. However, the earnings are taxed as ordinary income. Further, they will be taxed at a taxpayer’s marginal rate, as the income is over and above any other income earned in the year the distribution from the Roth IRA is processed.

Assuming a marginal rate of 25%, you would owe a total of $19,998.79 in taxes.

Total Available for Education:  $149,996.37

Taxable Account

A taxable account holds an advantage over a Roth IRA for education because of the way gains are taxed. While a Roth IRA’s earnings are taxed as ordinary income, in a taxable account the gains receive preferential capital gains treatment. While there will be interest and dividends that may be taxed as ordinary income, the overall result favors a taxable account.

At a marginal rate of 25%, the rate on capital gains is just 15%. With tax-efficient investments, most of this tax can be deferred until the money is used for school. While there may be some tax on interest and dividends annually, you can minimize this amount. Assuming for the sake of simplicity that the earnings are taxed at the capital gains rate, you would pay a total of $11,999.27 in taxes. (Those in the 10% or 15% marginal tax bracket would pay no taxes on qualified dividends or capital gains.)

Total Available for Education: $157,995.89

Tax Nuances

  1. Taxable accounts will generate dividends & interest: As noted above, there will likely be taxes due on interest and dividends annually from a taxable account. With tax-efficient investments, however, I don’t believe this would change the result that a taxable account is a better way to save for education expenses than a Roth IRA.
  2. Roth distributions could put you in a higher tax bracket: If you take significant contributions to cover tuition and other educational expenses, this could move you into a higher tax bracket. If this were to happen, you’d have less money available for the child’s education.

Final Thoughts

The big unknown in all of this is whether a child will attend college. This is particularly uncertain in the early years. Given this uncertainty, here are the best options if–

We assume a child goes to college:

  1. 529 Plan
  2. Taxable Account
  3. Roth IRA

We assume a child does not go to college:

  1. Roth IRA
  2. Taxable Account
  3. 529 Plan

Specific circumstances could change this order. For example, those who will turn 59 1/2 before or while their child is in college may prefer a Roth IRA. Likewise, those in the 10% or 15% marginal tax bracket may favor taxable accounts. The key is to understand that you must consider specific situations before making a decision.

Here are three final things to consider. First, you can now use a 529 plan for K-12 expenses, though you’ll need to look carefully at how your particular plan is handling this rule change. If you think your child will go to a private high school, you can take distributions a little early, even if they don’t go to college.

Secondly, you can change the beneficiary of a 529 plan. If one child decides not to go to college, you can change the beneficiary to another child. Or you can even use the funds to further your own education.

Finally, the best approach for most families may be to use two or more accounts. If you want to save $5,000 a year for college, for instance, you might save some in a 529 plan and some in either a taxable account or a Roth IRA. Just be sure to check out your state’s particular tax advantages, and consider saving at least enough in the 529 to net these benefits.

In all, these are complex issues that can affect things like future financial aid eligibility. So it may be best to talk with a professional who can look at all the particulars of your situation and help you make a plan.

Author Bio

Total Articles: 1083
Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Article comments

Eileen says:

Hello Rob,

I have gone through various podcasts on PF and yours is my favorite, thanks. You are very easy to listen to, intelligent ,informative and (sorry to say this) keep it about the topic instead of digressing into your “own story” as some other podcasters unfortunately do. Plus I miss DC where we used to live (Arlington) so it’s nice to know that’s where you’re coming from.

Anyway my question about Roths vs other savings vehicles for college. What if by the time your kids go to college you or spouse is over 60? Then you can take everything out? That was my thinking in addition to not knowing how much to put in a 529 if they decided not to go or had some other opportunity.


Rob Berger says:

Absolutely. If you’ll be 59 1/2 or older, you can take money out of a Roth IRA without penalty or taxes. It makes it a much better option for education.

Paul Curley says:

Great article, and thank you for sharing the case study.

Andy Farmer says:

Another downside of tapping a Roth IRA comes into play if your child is receiving need-based financial aid. The FAFSA & CSS both include parent income in their formulas. The more money you make, the more you can afford to pay for jr to go to college. Withdrawing Roth (or traditional) IRA money to pay for college actually increases your apparent income which is considered in the following year financial aid calculation. This is in addition to increased income taxes and tax bracket considerations – even if no penalty applies.

Sabrina says:

And, this is not the case if you use money from a regular, taxable account to pay for college, and you are over 60? FAFSA is not affected by how much you have managed to squirrel away?