Roth IRAs have a lot going for them – investment options and tax benefits are just two advantages. One area where Roth IRAs are not advantageous is when it comes to paying for college, especially when there are better options. Keep reading to see why using a Roth IRA to pay for college is a bad idea – and then learn four reasons why 529 plans are a better alternative.
Unlike many other investment accounts, Roth IRAs do not negatively impact financial aid applications. Regardless of how much money you have in your Roth IRA when your child goes to college, the balance is ignored for purposes of federal student aid calculations in figuring your Expected Family Contribution.
On the other hand, if you use funds from your Roth IRA, the situation is very different. Distributions received from your Roth IRA increase the income you are required to report on your federal aid application (FAFSA). Essentially, withdrawals from your Roth IRA make your child less eligible for need-based student aid.
529 plans are a better college savings account because tax-free distributions do not get reported as untaxed income on the dependent student’s FAFSA. The value of a 529 account is reported on the FAFSA unlike a Roth IRA. The impact is limited though because your EFC increase is capped at 5.64 percent of the account balance.
Four Reasons to Choose a 529 Plan over the Roth IRA
- 529 plans sometimes allow additional tax deductions or credits against your state income taxes. Roth IRAs, on the other hand, offer no such state tax advantages.
- Other family members can contribute to a 529 plan. Grandparents, uncles, aunts and friends can contribute to your child’s 529 account. No one except you can contribute to your Roth IRA accounts.
- 529 plans are professionally managed. This can help maximize your college savings and manage risk. 529 plan investing can often be simplified by choosing from age-based fund options available in nearly all 529 savings plans. On the other hand, a Roth IRA allows you to self-direct your investments, whereas a 529 plan does not; this could increase your risk as well as your investment potential.
- It is possible the same investment may be offered for a lower cost in your 529 plan. This often occurs because some 529 plans offer institutional versions of the same funds. Institutional funds are the exact same mutual funds as their regular counterparts, but generally with a lower expense ratio. The fees are usually lower even after adding in the 529 plan’s professional management fees. 529 plans are able to offer institutional funds due to the purchasing power of collectively large amounts of individual contributions. In Roth IRAs, you are on your own, so you do not benefit from the lower fees.