If you are saving for a child's education, or your own, you may be weighing the benefit of investing in a Roth IRA or a 529 plan. While 529 plans are designed for college savings, some people choose to invest in a Roth IRA and use those contributions to pay for school. There are benefits and drawbacks to both options.
Using a Roth IRA for College
Although early withdrawal from an IRA usually incurs a 10 percent penalty, there is an exception if the money is used to pay for your, your child's or your spouse's higher education expenses. Since you've already paid tax on contributions to the Roth IRA, you can take out the money without paying any tax. If you withdraw earnings before the IRA is five years old, you will have to pay tax on those earnings. Contributions you put into an IRA are taken out before the earnings, so if you invest enough and the account is less than five years old, you may not have to pay any tax at all.
Using a 529 Plan
Contributions to a 529 plan are also made after you've paid tax on the money, so any money you withdraw is tax free. Earnings on the 529 plan are also not taxed by the federal government. Since 529 plans are administered by each state, the rules for state taxes vary from state to state. For example, you usually need to name a beneficiary for the plan if you're saving for your child's college tuition, and you name him as the beneficiary. If your child decides not to attend college, you can change the beneficiary.
You can only invest $5,000 per year in an IRA or $6,000 if you are over the age of 50. The limits for a 529 plan are usually much higher, sometimes higher than $200,000. There are income limits for investing in an IRA as well. If you are single and earn more than $122,000 per year, you cannot contribute to an IRA at all. If you earn between $107,000 and $122,000, you cannot contribute the $5,000 maximum.
Savings in a retirement account are not considered assets on the Federal Application for Student Aid (FAFSA). However, savings in a 529 are, and they can reduce the amount of need-based aid you or your child receives. Once you use money from an IRA to pay for college it is considered income and can reduce the amount of aid you receive the following year. If you do not use the money in a Roth IRA to pay for college, you can always use it for retirement. Money in a 529 plan must be used to pay for higher education or else it is subject to a 10 percent penalty and income tax on the earnings.
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