When most people think about saving for college, they immediately think of saving in a 529 college savings plan. A 529 plan is account run by the state for purposes of saving for college expenses. You may have also heard about Educational Savings Accounts (or ESAs) and wondered if they have any advantages over a 529. Or what about using a Roth IRA for college savings? Let’s take a look at the pros and cons of these three different types of accounts.

Pros of 529 College Savings Plans

• State tax deductions may be available on contributions. In Ohio, the first $2,000 of contributions per year per beneficiary qualifies for a state tax deduction.
• Grows tax free.
• Contributions can be withdrawn federal tax-free at any time (for any reason), because it was post-tax money, but state tax penalties may be due if a deduction was taken at the time of contributions.
• There are no income taxes on withdrawals, if used for post-secondary educational expenses.
• 529s that are owned by parents are counted as assets for the student for financial aid purposes (as opposed to income) and only have a small effect on financial aid.
• Money can be used for any post-secondary educational expenses including tuition, fees, books, supplies, and room & board.
• 529s have no income limits for contributing.
• Beneficiary can change at any time, so if the intended student doesn’t use the whole account, it can be changed into the name of anyone else (sibling, parent, grandchild, niece, nephew, etc).
• There is no time limit on using the account.
• Contribution limits are very high (around $235,000 to $400,000 lifetime), although the limit for a state tax deduction will be lower.
• Beneficiary of a 529 can be any age.
• Tax penalties can be avoided in cases of students whose college expenses are paid for with scholarships, GI bill tuition benefits, or those who attend military academies.

Cons of 529 College Savings Plans

• Money must be used for education-related expenses to avoid tax penalties (although it can be transferred to a different person).
• 529 plans are run by the state and can have limited investment choices. Keep in mind that you are not required to use your own state’s plan, though, so you can choose one with better options if your home state is lacking. Keep in mind that you will likely miss out on any state tax benefits if you don’t use your own state’s plan.
• 529 accounts owned by grandparents (or anyone other than the non-custodial parent) and used to pay for the child’s tuition can count as student’s income and greatly effect financial aid.

Pros of ESA vs 529 College Savings Plans

• ESAs (or Educational Savings Accounts) are not state-controlled, so they may have more investment choices.
• You can use an ESA to pay K-12 educational expenses, so they’re a good choice for families with students in private K-12 schools.
• All other tax benefits are similar to the 529.

Cons of ESA vs 529 College Savings Plans

• There are income limits on who can contribute.
• Maximum contributions are only $2,000 per year.
• You must use ESA money by the time the beneficiary is 30 years old.
• Beneficiary of an ESA contributions must be under 18.
• ESAs frequently have fees associated with maintaining the account.
• No state tax advantages.
• Child owns the asset, which means it affects financial aid more than a parent-owned 529.

Pros of Roth IRA vs 529 Plans

• Roth IRA money can be used for the parents’ retirement, if it’s not used for college expenses.
• Retirement accounts are not calculated in financial aid formulas, if there are no withdrawals.
• Like 529s, contribution amounts can be withdrawn any time, for any reason (including college funding or family emergencies).
• Earnings can also be withdrawn for educational expenses, without early withdrawal tax penalties.

Cons of a Roth IRA vs 529 Plans

• Withdrawals of earnings from a Roth IRA for college expenses are exempt from tax penalties, but they are not exempt from income tax, unlike 529 educational withdrawals.
• Withdrawals from a Roth IRA for college expenses are counted as student income for the following year’s financial aid. This GREATLY effects the student’s financial aid eligibility. For this reason, I would encourage using caution in planning to use a Roth IRA for the purpose of college savings. This problem can be avoided by waiting until late in the child’s college career to use the Roth IRA money, so that there is no “next year”.

Bottom Line: 529 vs ESA vs Roth IRA

If you’re confident that your child will go to college, you should consider a 529 account. Even if the child gets a full-ride scholarship, you can use the 529 money for other college-related expenses or withdraw the amount equal to the scholarship without penalty. There is also the flexibility of transferring the account to someone else’s name. In the unlikely, worst case scenario of having no one to use the 529 account, the tax penalty for withdrawing the money for non-educational use is only 10% on the earnings portion of the account. Remember that to get the most tax benefits and financial aid, put the 529 in the custodial parent’s name, not the student, grandparent, or non-custodial parent.

I don’t see any advantages to using an ESA, unless you need it for K-12 educational expenses.

Roth IRAs are excellent for retirement saving and you can use them as a “last resort” for college expenses, but I don’t think they should be your primary method for college savings. The financial aid and tax benefits of the 529 outweigh the flexibility of the Roth IRA, in my opinion.

I have an Ohio 529 account for each of my kids and we contribute a small amount each month. My parents also kindly contribute to their accounts for their birthdays and Christmas. Even at ages 7 and 8, my kids understand what that means and they really appreciate it. It doesn’t hurt that my niece recently graduated from college, and my kids can’t wait to go to college like their cool big cousin!

Are you saving for college for you children? Which kind of account do you use? Comment below!

Sources:

• State Tax Deductions for 529 Contributions from FinAid
• Educational Savings Accounts vs. 529 College Savings Plans from Wiser Women
• Which is best: 529 college savings plan or Roth IRA? from Savingforcollege.com
• The truth about scholarships and 529 plans from Savingforcollege.com
• New GI Bill pays college from Savingforcollege.com