LeAnn Luna

Saving for College?

Section 529 plans are a tremendous education savings vehicle, but advisors should be aware of two competing options — the Roth IRA and Education Savings Accounts (ESAs).

December 13, 2007
by LeAnn Luna

Section 529 College Savings Plans (“529 plans”) are a tremendous education savings vehicle. However, before unilaterally recommending a 529 plan, CPA advisors should be aware of two competing options — the Roth IRA and Education Savings Accounts (ESAs). For families with limited means and income below the AGI thresholds, these simple and widely available vehicles might be a better first option than the 529 plan.

The choice depends on factors unique to each family. For education, the most important factors include tax treatment of contributions and withdrawals, family income, effect on financial aid, and the family’s savings goals, including the importance of fees and investment flexibility. This article discusses these elements in the context of choosing a vehicle for college savings.

READER NOTE: There is a helpful comparison chart at the bottom of this article.

Roth IRAs

The Roth IRA is a tremendous option for virtually all taxpayers who meet the adjusted gross incomes (AGI) limits. For 2007, contribution phase-outs begin at $99,000 for singles and $156,000 for joint filers. The per-person annual contribution limit is $4,000 for 2007 and increases to $5,000 in 2008. Individuals can make these contributions even when spouses are covered by a retirement plan at work.

Three attractive features make the Roth IRA a good first option, whether the goal is to save for college or for retirement. First, the ordering rules assume Roth withdrawals come first from contributions and then from earnings. Owners can withdraw contributions tax-free and penalty-free at any time and for any reason. Some families hesitate to set aside money irrevocably for education at a young age because they need those funds for future unexpected emergencies or major purchases, such as a home. For these families, the Roth is an essentially risk free way to set aside money for the future because parents can “change their mind” at any time and withdraw any contributions should the need arise. If Roth investors use the funds for qualified education expenses, withdrawals in excess of contributions are subject to income taxes (if prior to age 59½) but not the 10 percent early withdrawal penalty.

Second, a parent’s Roth balance does not count against the student for financial aid purposes. Withdrawals included in taxable income affect aid calculations, but only in the year after the withdrawal. Finally, investors will appreciate the flexibility of the Roth, which offers essentially unlimited investment options and low annual maintenance costs if held at one of the discount brokerage houses.

Coverdell Education Savings Accounts (aka “Education IRAs”)

Like Roth IRAs, contributions to Education Savings Accounts (ESAs) are not deductible, and earnings grow tax-free. Unlike Roth IRAs, ESA withdrawals for qualified education purposes are tax-free. Qualified expenses include most college costs (room, board, books) and also tuition for primary and secondary schools. Since most brokerage firms offer an ESA for a nominal fee, the plans are inexpensive and investment options are essentially unlimited.

ESAs do have a number of important limitations. There is an AGI phase-out limit, which ranges from $95,000 to $110,000 for single taxpayers, and from $190,000 to $220,000 for joint filers. Annual contribution limits are relatively low at $2,000 per year per child. Finally, the Lifetime Learning Credit and/or the Hope Scholarship Credit cannot be combined with tax-free ESA withdrawals in any one year. ESAs are taxed as parental assets for financial aid purposes.

For most parents, the ESA is preferable to a 529 plan only if the annual savings amount is low (less than $2,000) or the funds will be used for a private primary or secondary school. The simplicity, low cost and investment flexibility are significant positives. However, for many parents the relatively low contribution limits and income phase-outs will make 529 plans a superior choice.

529 Plans

529 plans are an obvious choice for wealthier investors or for those with substantial available assets that they want to designate for education. The plans have no AGI limits and essentially no annual or overall contribution limits (contributions must end when the account reaches a set limit, in many states $250,000 or more). Gift tax treatment is also favorable since contributions are considered completed gifts even though parents can withdraw the money or change beneficiaries at any time. In addition, more than half the states offer tax benefits, primarily to investors that invest in their home state plan.

Investment options are limited to the options determined by each plan, but in recent years competition has spurred states’ efforts to offer broader and more appealing choices. Most investors can find a plan that fits their investment priorities among the dozens of choices available. Annual plan expenses are still relatively high, but competition has also brought these costs down in recent years.

Under current law, assets in a 529 plan are taxed as parental assets for financial aid purposes. And unlike ESAs, 529 plans only extend preferences to students attending college or vocational schools.


Even with the clear benefits of 529 plans, the simpler Roth and ESA are worthwhile options to consider for some of your clients. The Roth in particular is a good first step, particularly for reluctant savers with young children. The funds are available for college, but can be withdrawn without penalty for emergency purposes. Furthermore, parents can defer the funding decision (loan, savings, scholarships) until college arrives and retain the funds for retirement if at that time retirement needs trump avoiding college loans. Roth IRAs will not affect the amount of available financial aid.

Comparison of Features

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LeAnn Luna is an assistant professor and holds a dual appointment with the Department of Accounting and Information Management and the Center for Business and Economic Research, both at The University of Tennessee.