529 Plan vs. Roth IRA: What's the Best Way to Save for College? (2024)

Fun Fact: It’s possible to use retirement funds to help pay for children’s college expenses.

Although there are a plethora of articles of how parents can use their retirement savings to pay for their kids’ college (I love my [future] children…but no), I’ll explain how you can CREATE a retirement account for your children and use THAT to pay for their college expenses. Also, I’ll explain why this retirement account is a better tool than a 529 plan.

I’m about to drop some gems here. But first, let me describe a few college savings plans and retirement plans already out there.

Normally, you can withdraw funds from your own individual retirement account (IRA) without penalty to pay qualified higher education expenses. You can also borrow from your 401(k). As you will learn through this article, I believe the Roth IRA for your child is the best means of paying for their college education.

What is a 529 plan?

A 529 Plan is a college education savings plan operated by a state, financial, or educational institution. It is designed to help families set aside college savings for future costs. 529 Savings Plans work by investing your contributions in mutual funds or similar investments. Your account will go up or down in value based on the performance of the particular option you select. There are generally two types of 529 plans from state to state.

529 Prepaid Plans let you pre-pay all or part of the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges. The Private College 529 Plan is a separate prepaid plan for private colleges. Great if you already know where your kid is going to go years before they’re born! Go [insert your alma mater]! As long as the plan satisfies a few basic requirements, the federal tax law provides special tax benefits for these plans. Generally, the same tax benefits also exist at the state level.

A 529 sounds litty (in a boring tax law kind of way). What’s an IRA?

If you’ve been reading through Wealth Noir like I know you have, you know thatTraditional and Roth IRAs (individual retirement accounts) are types of investment accounts that comes with tax benefits to help you save for retirement. This is a retirement account separate from any 401(k) your job may offer (seriously, contribute to both if you can). Currently, the annual contribution limit for an IRA in 2017 is $5,500 or $6,500 for savers over 50 years old.

There are two main different types of IRA: Traditional IRA and Roth IRA.

Traditional IRAs allow you to contribute up to the full $5,500 per year in a tax-me-later account. You pay taxes on your money only when you take it out of the account. Just don’t take it out before you turn 59.5 years old, or Uncle Sam takes an extra 10% penalty tax slice off your plate and eats it right in your face. Plus, every year you contribute to your IRA, you can claim a tax deduction for the contribution. [insert Obama “not bad” meme]. This type of IRA is for those where stuntin’ is a habit (i.e. you earn too much for a Roth).

Roth IRAs are different from Traditional IRAs for a few reason. First, Roths are lowkey the wave because you pay taxes on the $5,500 contribution the year you deposit the money. Then you never get taxed on anything in the account again (assuming you don’t take out the gains before 59.5 years old). Any money made on the account grows TAX-FREE FOR YEARS. Yup, all kinds of gains.

As I mentioned, the downside for a Roth is the income restrictions to qualify for a Roth. In 2017 the limits were up to a $118,000 annual salary for those single and ready to mingle and up to $186,000 for those married households where sitting on the couch watching a “This Is Us” marathon for hours before going to bed at 10 pm, because y’all have work in the morning, is a good weeknight. Wait … did I just tell on myself there?

OK, that was a lot, but I’m still awake. If an IRA is meant for retirement, how can it be used for college and why?

FinAid.org does a great job of explaining here. A snippet from their explanation follows:

“Normally, if you withdraw money from a traditional or Roth IRA before you reach age 59-1/2, you would pay a 10% early distribution penalty on the distribution, in addition to any regular income tax due. There is, however, an exception for distributions used to pay qualified higher education expenses. The portion of the distribution used for qualified higher education expenses is exempt from the 10% early distribution penalty. You will still pay income tax on the portion of the distribution that would otherwise have been subject to income tax. All this exception does is avoid the 10% additional tax on early IRA distributions. The qualified higher education expenses must be for you, your spouse, your children or your grandchildren. Qualified higher education expenses include tuition, fees, books, supplies, and equipment, as well as room and board if the student is enrolled at least half-time in a degree program.”

The advantages of avoiding early withdrawal penalty are:

• This effectively can turn an IRA into a tax-deferred college savings vehicle.
• Funds in an IRA are sheltered from the financial aid need analysis, and so have no impact on financial aid eligibility.
• If you limit your withdrawals from an IRA to just the contributions, the distribution is tax and penalty free when used for qualified higher education expenses.

The disadvantages of using penalty-free withdrawals are:

• Although the amounts in an IRA are sheltered from need-based financial aid, the amounts withdrawn may count as income and affect eligibility for need-based financial aid during the next year.
• You are using up retirement savings. Once the money has been withdrawn from the IRA, you can’t put it back. The only way to increase your IRA balance is through the normal contributions, which are subject to the annual limits.
• Qualified education expenses can be used to justify only one education tax benefit. You can’t double-dip. If you use them to justify a penalty-free withdrawal from your individual retirement account, you can’t use the same expenses to justify a Hope Scholarship, Lifetime Learning tax credit, etc.

As such, the best advantage would be to use a Roth IRA, which you can pull out without a 10% early withdrawal penalty. To show you how it works (source: US News):

1. Assume you have contributed $30,000 into a Roth IRA that has grown to $45,000 with earnings over time.
2. You can use up to $30,000 – the contributed amount – to pay for school expenses without any further tax liabilities.
3. However, for you to avoid the 10% early withdrawal penalty, the Roth IRA must have been established at least five years before the first withdrawal. Again, withdrawals from a Traditional IRA can also be used to pay for educational expenses, but lack the same advantages of a Roth IRA and are subject to federal and state tax.”

Ok put me on game. How do I fund an IRA to save for college?

Now that we covered the “what” behind this system, we’ll tackle the “how.” Again, I started this article by saying your kids will pay for their own college…kind of. Instead of you paying out of your retirement account for your kids to party for years, you can set up an IRA for them to party for years. YAY college!

How, Sway?

Linda, listen. I have the answers. Although this is not a strategy regularly employed, it’s one that can work by following these steps and not trying to deviate.

1. Open (at least) two LLCs, one for yourself and one LLC for each one of your children’s businesses individually. There are a lot of hustlers out there with a side business; protect ya neck by opening an LLC for your business. Do the same by opening an LLC for each of your children individually.
2. Open an IRA for each one of your children individually. As for the IRA, anyone under 70.5 years old can have an (preferably Roth) IRA as long as they have a social security number. Any parent can open an IRA for their child fresh out the womb. Again, all you need is a social security number and the fees associated with this cost.
3. Pay your children. If Jr. has an LLC in his name (again there is no age restriction for creating an LLC), up to $5,500 of any earned income is eligible for contribution into an IRA annually. Have your children work for your business, and pay their LLC. Just make sure to document all expenses, billables, account receivables, etc. for both your and your children’s LLC. More detail for this step listed in Step 4 below.
4. Fund the IRA with the earned income annually. The profits from their LLC will fund their IRA. Take the profits from your children’s LLC, up to $5,500 currently, and deposit it into their IRA. Again, to fund any IRA, you need an earned income eligible for contribution into the IRA. Unfortunately chores around the house and allowances will not count as earned income for contribution purposes. To meet the earned income requirements, I’ve heard of parents paying their children for help shredding paper, stamping envelopes, yard work for others’ households, babysitting others’ children, demo work for the family’s real estate business, use of their children’s likeness and image for their family business, etc. This would count as earned income eligible for contribution into an IRA.
5. File Jr.’s taxes with your own. This is a very important step. Make sure your dependent children file a tax return with the family’s annual tax return.
6. Withdraw funds only to fund college expenses. Finally, sit back, relax, and watch Jr.’s college IRA fund grow tax free for 18 years. Slightly complicated process, yes, but the reward is worth it.

Again, like many other tax planning strategies in recent years (I’m looking at you, backdoor Roth IRA), this is a new strategy chartering the unexplored, but it can be successful by doing the work and not taking shortcuts. Below are a few pros and cons of using this approach:

Pros of this approach:

• Assuming growth for 18 years, your child has at least about $100,000 for college by freshman year.
• All contributions to the Roth are able to be used for college tax-free while still allowing any gains to accumulate for retirement.
• Nas and Jay Z will be proud of you.

Consof this approach: (sorry if the list is long. They trained me to prepare for all worst-case scenarios. Also, I’m not letting y’all take my license away from me because I didn’t warn you):

• As of 2017, you can only contribute up to $5,500 per year to an individual IRA. Again, as of 2017, 529’s have no contribution limits.
• One problem with using a Roth IRA to pay for college or grad school is it may impact financial aid. Students who apply for need-based financial aid are required to report income and asset information on the FAFSA. Money held in retirement accounts, such as a traditional or Roth IRA, are assets exempt from being evaluated on the FAFSA for financial aid. However, withdrawing funds from an IRA account will count as income the following year.
• Using this strategy will require a bit of paperwork and prior proper planning. You will have to find a way to make eligible contributions to fund your child’s IRA. This means they have to have some type of earned income. Doable, but a bit tedious. Make sure you discuss this plan with a financial advisor and an attorney. Don’t get caught out here in these streets with the IRS congratulating you for playing yourself.

Finally, for those who are thinking, “What about any money left over after scholarships and when school ends?” Good news for your child; they now have a retirement account! THIS is the big advantage over the 529. Money locked in a 529 can ONLY be used for educational expenses. Once college is over, the money left over can be passed to another relative for, guess what?: educational expenses. It’s either that or withdraw the funds and risk paying that pesky 10% federal (and varying state) tax ON TOP of regular income tax.

“Well, then that 529 money can just be rolled into one of those cool IRA accounts.” NOPE. Money in a 529 not used for educational expenses are stuck there growing larger in investment purgatory virtually unable to be touched for until the end of perpetuity (aka *in Cardi B voice* forever). Start off with the Roth for your kids because college is expensive. Ain’t nobody got time for student loans in 2050.

Final note – for all those out there fact-checking my every semicolon, the Coverdell IRA IS NOT the same as the strategy I advocate above. The Coverdell IRA is created specifically for educational expenses, NOT retirement funds. It’s far too similar to a 529. Stay up out of my comments with all that hate, fam. Be blessed.

See, you mad, but I just put you on game for $free.99.

Austin Edwards, Esq. is a lawyer and a personal financial consultant working specifically with Millennials. After years of working at a Big Four financial firm serving clients’ litigation needs and handling their personal assets and estates, Austin turned his talents and passion for building wealth into a business serving the financial needs of underrepresented communities. His motto: “no budget is too small to build upon.” He can be reached on Instagram @AJEdwardsEsq.

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