Parents who want to save money for their own retirement and save money for their children's college expenses have many complicated choices. One of the most basic and important is where to invest the money.
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For example, parents who want to protect their savings from taxes can choose among 529 college savings accounts and Roth IRAs. Both types of accounts require investors to contribute after-tax money. And they both allow tax-free withdrawals of those contributions for children's college expenses. But there are many key differences, including limits on who can use them, state tax liabilities, and investing options.
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To help you make the best choice, here is a list of frequently asked questions comparing the two kinds of accounts:
Q: Can I start saving with a very small amount of money or with small monthly payments?
529: Yes. Some states and plans allow you to start by contributing as little as $15 a month.
Roth IRA: No. Most fund companies require minimum initial payments of at least $2,500 a year or $200 a month.
Q: Are there credit card and shopping rewards programs to help accelerate my savings?
529: Yes. Upromise, Fidelity, Babymint, and Tuition Rewards all offer attractive programs. You can use all of these together and ask relatives to sign up as well to get more free money deposited in your account.
Roth IRA: Yes, there are a few. Fidelity has a credit card that will rebate a small percentage of your spending back to a retirement account. But 529s have more rebate options.
Q: Can relatives or friends contribute?
529: Yes. Many plans make it very easy for others to contribute tax-free to your child's college savings plan.
Roth IRA: Yes. But generally it is easier to persuade relatives to donate to your child's college fund than to your retirement fund.
Federal Tax Questions
Q: Can I deduct my contributions from my federal income taxes?
Roth IRA: No.
Q: Do I pay extra federal taxes if I just withdraw the amount of money I contributed?
Roth IRA: No.
Q: Do I pay federal taxes on any of the earnings or profits I spend on college tuition?
Roth IRA: Yes, if you are under the age of 59 ½ and haven't waited five years since contributing.
Q: Can the money be used without penalty for college living expenses as well as tuition?
529: Yes, if the student is attending college at least half time.
Roth IRA: Yes, if the student is attending college at least half time.
Q: What happens if I don't need the money for my children's college expenses?
529: You can shift the beneficiary to pay for college expenses for anyone in your immediate family, including spouses, grandchildren, and first cousins. If you decide you want to use the money for other purposes, you pay taxes on earnings plus an additional penalty of 10 percent.
Roth IRA: You can save the money for your retirement and then withdraw it without penalty for any reason after you are 59 ½ and have saved it for at least five years.
Q: What federal tax penalty do I pay if I withdraw the money for an emergency?
529: You must pay regular income taxes on your profits (if any) plus another 10 percent as a penalty.Roth IRA: You pay regular taxes on your profits but won't be charged a penalty for certain permitted uses, such as making a down payment on a home or paying health insurance bills during unemployment. If you withdraw your profits for a non-approved emergency, you have to pay regular income taxes on your profits plus a penalty of an additional 10 percent.
Q: Are there limits on how much I can contribute and protect from taxes?
529: Yes, but the limit is very high. The federal government says contributions to 529s cannot be more than the "amount necessary to provide for the qualified education expenses of the beneficiary." Some states set limits as high as $300,000.
Roth IRA: Yes. Couples of any age who earn more than $176,000, and singles who earn more than $120,000, cannot contribute to a Roth IRA. Those who earn less than the cutoffs and are over age 50 can contribute up to $6,000 a year. Those who earn less than the cutoffs and are under 50 can contribute $5,000 a year.
State Tax Questions
Q: Do I get a state tax break on contributions?
529: Yes, in 34 states. The states where there is no state tax advantage are: Alaska, California, Delaware, Florida, Hawaii, Kentucky, Massachusetts, Minnesota, New Hampshire, Nevada, New Jersey, South Dakota, Tennessee, Texas, Washington, and Wyoming.
Roth IRA: Generally, no. But a few states give breaks to those with very low incomes who contribute to retirement savings accounts.
Q: If I get a state tax break, how much does it save me or add to my earnings?
529: The average is $87 per $1,000 invested, according to Morningstar. But the range starts at a low of $30 per $1,000 in Illinois to as much as $566 for the first $1,000 invested in Maine to parents of newborns (thanks to a state matching grant).
Roth IRA: Nothing (although a few states offer a break to low-income individuals).
Q: Can I invest the money however I want?
529: No. Most plans give investors choices of only a few kinds of funds. And some states don't offer any low-cost choices. But some state options, such as Alaska's T. Rowe Price savings plan and Maryland's College Investment Plan, have low fees and get high ratings for their investment strategies from Morningstar and Savingforcollege.com.
Roth IRA: Yes.
Q: Can I invest in something I am guaranteed will keep up with tuition inflation?
529: Maybe. A few states offer "prepaid" tuition plans that say they will keep up with tuition inflation, but their guarantees aren't ironclad. A consortium of private colleges also offers a prepaid plan, but the guarantee is only good if your child attends one of the participating colleges.
Roth IRA: No.
Q: Can I pick a fund that will do all the reallocating every year so I don't have to make the investments more conservative each year?
Roth IRA: Yes.
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