There are many options for tax-deferred or tax-free savings. One option is a Roth IRA and another is a 529 college savings plan. But, while both offer a way to save money for your future, their purpose is vastly different. Before you put any money towards either of these plans, you should understand the difference between these programs.
A tax advantaged plan like a 529 plan or Roth IRA helps you save money by eliminating the tax due on these accounts when money is withdrawn. Both plans encourage saving money for a specific purpose. Each plan is also a government sponsored and authorized tax shelter. The Roth IRA is subject to IRS rules, while college savings plans are generally subject to IRS rules, and some are administered by state governments.
The Roth IRA is designed to help you save money for retirement by allowing you to make after-tax contributions to the plan. Money can be invested in a variety of investment products including mutual funds, real estate, individual stocks, and even precious metals. Money withdrawn from a Roth IRA is tax free. Additionally, after-tax contributions to a Roth can be withdrawn at any time. However, interest earned on your principal amount may only be withdrawn after age 59 1/2.
529 College Savings Plans
529 college savings plans are specifically designed for saving money for college or higher education expenses. Investments are generally limited to mutual funds or similar vehicles. The plans are also administered by state governments. Withdrawals for higher education are tax free. But, if you do not withdraw money for higher education expenses a penalty may apply depending on what you are using the funds for. Also, you will be subject ordinary income tax on the withdrawals. Some states may, at their discretion, close your 529 plan if they feel you are not going to use the funds for higher education expenses, to prevent abuse of the plan.
One misconception about 529 and Roth IRA plans is that they are both regulated at the federal level. While the IRS does set the rules for how 529 plans are taxed, many 529 plans are actually run by individual states, so each plan will be slightly different depending on the state that you live in. Roth IRAs, on the other hand, are all the same in terms of the contribution rules, investment options, and withdrawal rules, because they are regulated at the federal level only.
Before investing in either a Roth or a 529 plan, you need to be sure that you will use the plan for its intended purpose, and that your financial goals are clear. Both plans are highly specialized, meaning that they are designed for a specific purpose. You should use the 529 plan exclusively for education savings, and you should use the Roth IRA exclusively for retirement savings.
- "Practicing Financial Planning for Professionals, practitioner's 10th edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
- "Life & Health Insurance, License Exam Manual, 6th Edition"; Dearborn Financial; 2004
- http://www.domini.com: Withdrawing money from a Roth IRA
- http://www.savingforcollege.com: What is a 529 college savings plan?
- Photo Credit dollars image by Mikhail Olykainen from Fotolia.com
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