If you’re saving for a college fund, you may have considered putting that money into your Roth IRA. The question is whether this is a good idea and if it will save you money.
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When would a Roth IRA be a better choice than using a 529 account? Here’s what you need to know to make that decision.
529 Accounts for College Funds
A 529 account is a special type of savings plan designed to help pay for education. These accounts offer you tax advantages if you are saving for college and other forms of education.
If you put money into a 529 account, it will grow tax-free as long as you use it for qualified educational expenses such as tuition, books and room and board. Some states may also offer state income tax deductions or credits for contributions, which can be beneficial since the money will also not be taxed when withdrawn to pay for college later.
However, 529 accounts have some limitations. If you use the funds for anything other than educational purposes, you’ll face taxes and a penalty on the earnings. This can become a problem if the person you created the fund for chooses not to pursue higher education or gets scholarships that cover a part, or all, of their educational costs.
There’s one more thing to consider — 529 plans may impact a student’s eligibility for need-based financial aid because they are considered parental assets when calculating federal financial aid. Therefore, your child may be more likely to get financial aid if you save in a Roth IRA.
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When Roth IRAs Might Make More Sense Than a 529 Account
There are some situations where it might make more sense to use a Roth IRA for your child’s college fund.
Both Roth IRAs and 529 plans are funded with after-tax dollars — you pay tax on your income before investing in the account. With either account, your investments will grow tax-free.
However, there are some key differences when it comes to withdrawing your money. With a 529 plan, you can withdraw both your contributions and any investment earnings tax-free and penalty-free, as long as the money is used for educational expenses.
With a Roth IRA, you can withdraw your contributions — the total amount of money you have put into the account, tax- and penalty-free at any time for any reason. However, if your investments have gone up in value and you want to withdraw those extra earnings, it’s a bit more complicated.
If you have had your Roth IRA for less than five years and you are under 59.5 years old, you will have to pay taxes on the earnings and a 10% penalty. If you are younger than 59.5 but have had the account for more than 5 years, you won’t have to pay a penalty, but you will still pay taxes. Finally, if you’re older than 59.5 years and have had your account for more than 5 years, you will be able to withdraw any extra earnings completely tax-free.
This means if you will be over 59.5 years old when your child goes to college, a Roth IRA might make more sense than a 529 account. Part of the reason is that if your child doesn’t go to college, you can keep that money for your retirement or any other purpose without penalty.
Using a Roth IRA may also be a good idea if you are saving for your retirement and the college fund in the same account and don’t plan to withdraw any money outside your initial contributions before you are 59.5 years old.
The Bottom Line
If you won’t be 59.5 before your child is college-age, then you have to weigh the tax pros and cons: Are you fine with paying a penalty if you withdraw the money you put into a 529 savings account should your child choose not to attend college? Does that outweigh the benefit of tax-free withdrawal with an IRA?
Everyone’s financial situation is different, so it may be a good idea to consult with a financial professional before making a decision. Ultimately, you want to make a sound decision that makes your investments worthwhile, both now and in the future, for you and your child.
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This article originally appeared on GOBankingRates.com: The Pros and Cons of Saving for College With a Roth IRA
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