As a parent, setting aside money for your child’s higher education could be an important part of your ongoing financial strategy. The 529 and Roth IRA are two types of tax-advantaged plans that you might want to consider as you prepare for your child’s future.
What is a 529 savings plan?
A 529 plan is a simple way to invest money and watch it grow. Your accounts are managed for you, so you can basically just set it and forget it. There are two types of 529 plans to choose from:
Prepaid tuition plan – With a prepaid tuition plan, you can purchase credit toward tuition and fees at a participating college or university. Prepaid tuition plans are sponsored by state governments and require that you be a resident of the state to invest in their prepaid plan. That does not mean your student has to attend school in that state. Your prepaid investment can still be used to pay tuition for out-of-state institution as long as they participate in the 529 program.
Education savings plan – An education savings plan lets you open an investment account to save for tuition, mandatory fees and room and board. Withdrawals from education savings plan accounts can generally be used at any college or university.
529s are administered by the states, and each state has different rules about its plan. Contributions to a 529 are not deductible on your federal taxes, but some states offer deductions or credits when you make contributions to their in-state plans. Here are a few more facts about the 529:
- There are no income, age, or yearly contribution limits for 529 plans.
- If you withdraw money to pay for qualifying education expenses, you won’t have to pay capital gains tax on your investment earnings.
- You don’t have to report your contributions to a 529 plan, because they are not taxed. In fact, you won’t receive a Form 1099 to report taxable or nontaxable earnings until the year you make withdrawals.
- If 529 account withdrawals are not used for qualified education expenses, they will be subject to state and federal income taxes, plus a 10% federal tax penalty on any investment gains you made.
2018 Tax Law Changes to 529 education plans
The Tax Cuts and Jobs Act changed the rules regarding 529 education plans. For federal tax purposes, you can withdraw up to $10,000 per year, per child, to pay for private, public, and religious school expenses for grades K-12. These are considered qualifying education expenses, so you will not have to pay a federal tax penalty for these withdrawals. *As of October, 2018, it is not yet clear which states will adopt this rule for their own tax purposes.
What is a Roth IRA?
It’s true: the Roth IRA can be used for more than just retirement. If you are under age 50, the amount you can contribute to a Roth IRA is $6,000 per year ($6,500 if you are over 50). There is no federal or state income tax deduction for your contributions, but once your IRA has matured for five years, any withdrawals from your account are tax-free.
The Benefits of a Roth IRA for Education
If you take money out of a Roth IRA before you turn 59 ½, you’ll have to pay income tax and on your funds. But there is no penalty for early withdrawal as long as you are using the money for higher education expenses. Best of all, if you use a Roth IRA for education savings, any money you don’t spend on school expenses can stay put for your retirement later. (Read also: How much do I need to save to retire? )
This post is up to date for 2018 (returns filed in 2019).