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Saving for college with a 529 vs. Roth IRA

Highlights:

- 529 plans are designed to save for educational expenses, like college.

- Roth IRA accounts are generally designed to save for retirement expenses later in life (though they can also be used for educational expenses, with some caveats).

- Both accounts offer tax advantages, but picking the right one for your situation is important!

Saving for the future is an essential part of building financial stability. The government knows this, so they offer certain advantages to savvy savers. One common way that the IRS incentivizes saving is by providing tax breaks to savers who use certain types of accounts.

These so-called “tax-advantaged accounts” sometimes offer upfront tax breaks (a deduction when you file your taxes), or they might offer tax-free withdrawals if certain requirements are met. And in general, the benefits get super-charged when funds in these accounts are also invested and allowed to grow tax-deferred or tax-free.

We’ll dive into all the nitty-gritty details below. This guide will focus on two common tax-advantaged accounts: the 529 college savings plan and the Roth IRA. We’ll explain what each of these accounts are, and do a 529 vs. Roth IRA comparison.

What is a 529 college savings plan?

Student writing on a notebook

A 529 plan is a tax-advantaged savings and investment account that’s designed to help families save for higher education costs. There are actually two types of 529 plans — prepaid tuition plans and college savings plans — but this guide will focus on the more popular 529 college savings plan.

529 plans can be opened by adults in their own name or opened by parents with a child listed as the beneficiary. Funds can then be deposited into the account, and invested in a variety of assets, like stocks, bonds, mutual funds, and more — although investment options vary depending on the 529 plan administrator.

The hope is that the money you put in the account will grow and help you save for college. And there are tax advantages to using a 529 (which we’ll cover later on).

What is a Roth IRA?

Senior couple walking at a beach

A Roth IRA is a tax-advantaged retirement savings account designed to help individuals save for the future. IRA stands for individual retirement account, and Roth refers to the type of tax treatment that this account has.

The Roth IRA is primarily meant for adults to open on their own, although there is also a custodial account version that parents can open on behalf of their children. (Children still need to have their own earned income in order to contribute to a Roth IRA, however).

Roth IRAs are designed for investing. You contribute money, invest in assets like stocks and bonds, and continue saving/investing until retirement. The main tax perk of a Roth IRA is tax-free growth, which can be a big benefit in your retirement saving journey. 

Although Roth IRAs are primarily designed for retirement savings, you can also use a Roth IRA for college savings. 

Normally, when you withdraw funds from a Roth prior to retirement age, you’ll get hit with tax penalties. However, if the funds are used for qualifying educational expenses, you won’t pay any penalty — but you may still have to pay income taxes. 

We’ll dive into the details of how using a Roth IRA for college savings actually works — for now, it’s a good idea to keep in mind that this is a possibility. 

529 vs. Roth IRA: What are the differences?

Student putting a box in a car trunk

We’ve covered the basics. Now, what is the best savings vehicle for your goals?

Let’s look at a 529 vs. Roth IRA comparison to help you decide which account might be right for you. And remember, for personalized financial advice, talk to a financial advisor or financial planner.

Intended uses and savings goals

The biggest difference is that these accounts are designed for different purposes.

The Roth IRA is designed for saving for retirement but money can also be withdrawn for higher education expenses. The 529 plan is designed solely for saving for qualified educational costs.

529 plan vs. Roth IRA tax benefits

The tax benefits of Roth IRAs and 529s are actually somewhat similar.

These accounts don’t offer upfront federal tax benefits. You can’t deduct the contributions you make on your federal tax return like you can for traditional IRAs or 401(k)s. The real benefit comes from tax-free investment growth, so the tax perks come later on when you withdraw money. 

Once you put money into either of these accounts, you can invest it in various assets. From there, your investments can grow without being hampered by income tax or capital gains tax.

When money is withdrawn, it may or may not be taxed, depending on what you use it for. With a Roth IRA, withdrawals are tax-free and penalty-free as long as you’ve had the account open for at least five years and you’re over age 59.5. If you’re under 59.5 and the funds were used for qualified higher education expenses for yourself, your spouse, or your children or grandchildren, you will not owe a penalty. But you may have to pay taxes on part of the withdrawal. 

With a 529 plan, withdrawals are tax-free at any age, as long as they’re used for qualifying education expenses. It should be noted that 529 plan details vary a bit because each state has their own rules. Some states may offer state-level tax benefits as well. Check the details of your state’s plan for the full scoop.

So basically, both accounts can offer tax-free growth and tax-free withdrawals, as long as the accounts are used as intended and all requirements are met. You can meet with a tax professional for help determining your tax responsibilities.

Roth IRA vs. 529 contribution rules

A “contribution” is simply when you make a deposit into one of these accounts. It’s a bigger deal than a bank deposit, though, because taking your money out might be a bit more complicated than it would be with a bank account.

For a Roth IRA, contribution rules are pretty strict. You must have earned income, from a job, side hustle, or small business, in order to contribute (and parents can’t contribute for their kids). And you can’t contribute more than you earn in a year. The overall Roth IRA contribution limit is $6,500 per year or $7,500 if you’re over age 50, as of 2023.

The limit applies to contributions made to traditional and Roth IRA accounts combined. So if you contribute $2,000 to a traditional IRA this year and you're under age 50, you can then contribute up to $4,500 to a Roth IRA this year.

Additionally, Roth IRAs are subject to income limits. If you’re from a high-income household, you may not be able to contribute, or you may have to reduce the total amount you contribute.

For a 529 plan, rules are a bit more relaxed. There’s no annual contribution limit, and anyone can contribute to a 529 plan (even if it’s not their own). Parents, grandparents, and even friends can contribute to a 529 plan for a child’s college expenses. 

Keep in mind that 529 plans can affect financial aid eligibility when the student eventually fills out the Free Application for Federal Student Aid (FAFSA).

529 vs. Roth IRA withdrawal rules

A withdrawal is when you take money out of one of these accounts. (This may also be called a “distribution”). Again, it’s more complicated than a bank withdrawal, and there may be tax implications.

Roth IRA withdrawal rules

For a Roth IRA, money can be withdrawn penalty-free (and used for any purpose) starting at age 59.5, as long as you’ve had the account open for at least five years. These are considered qualified distributions and are totally tax-free and penalty-free at the federal level. Withdrawals made before age 59.5 are a bit more complicated.

At any point, you can withdraw the principal tax-free and penalty-free. The principal is simply the money that you directly contributed (but not the earnings portion/your profits). 

For instance, if you’ve contributed a total of $12,000 to your Roth IRA, but it’s now worth $20,000 due to your investment profits, you could withdraw up to $12,000 without any penalties or taxes. The reason for this is that you already paid taxes on the money you contributed.

If you withdraw profits before age 59.5, you’ll owe taxes on the profits you have made. Additionally, a 10% tax penalty may be applied. There are a few exceptions to this rule, like if you’re using your withdrawals to pay for a first-time home purchase. But what if you’re under 59.5 and you’re using the withdrawal for qualified educational purposes?

In that case, you will not be subject to the 10% tax penalty, but you may be subject to income tax — depending on whether you withdraw any of your IRA earnings.

Let’s look at an example: 

  • You open a Roth IRA and contribute a total of $5,000. At any time, you can withdraw this $5,000 you put in — without paying any taxes or penalties. 

  • You invest the money in assets like stocks and bonds. After a few years, the account balance has grown to $7,000.

  • You decide to withdraw $6,000 to pay your child’s tuition, and you’re 45 years old. It’s a qualified education expense, so you don’t have to pay a 10% tax penalty, but since you’re under 59.5, you will owe income tax on the $1,000 you withdrew that were part of your IRA profits.

Roth IRAs are most powerful when used for retirement savings because they offer tax-free withdrawals after age 59.5. But in some cases, they might make sense for college savings as well. 

529 withdrawal rules

For a 529 plan, money can be withdrawn at any time. You can withdraw as much or as little as you’d like. However, to gain tax benefits and avoid penalties, withdrawals must be for qualified educational expenses. 

You should withdraw money in the same calendar year as you incur the expenses to keep things simple for tax purposes. So if you pay for college tuition in 2024, be sure to withdraw funds from the 529 in 2024 as well. 

If you withdraw funds and don’t use them for qualified higher education expenses (or elementary/secondary school tuition), you’ll have to pay income tax on the profit portion of the withdrawal. Plus, you’ll likely be hit with a 10% tax penalty.

529s and Roth IRAs are just two investment options

Ultimately, these are two powerful accounts with two very different intended uses. If you’re saving for future educational expenses (for either yourself or a loved one), the 529 is likely a good fit. If you’re saving for your retirement, the Roth IRA likely makes more sense.

Whatever you choose, it’s best to get started with investing early. If you’re a teen, Greenlight can help you manage your money, learn about investing, and understand personal finances. And for parents, Greenlight is a powerful tool to help your kids learn financial literacy concepts

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