No matter if you’re saving money to pay for college for yourself or a child, it’s important to use the right account so you get as many benefits as possible. Laura answers a listener question about whether he should use an IRA or a 529 plan for the best results.
Shawn, congratulations on your new arrival and thanks for your question!
No matter if you’re saving money to pay for college for yourself or for a child, it’s important to use the right account so you get as many benefits as possible. In this post I’ll cover saving for college with an IRA and a 529 plan and recommend the best option to get the most for your money.
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What Is an IRA?
To answer Shawn’s question about using an IRA or a 529 plan for college savings, let’s start with a quick review of the two main types of IRAs and who can have them.
IRA is short for Individual Retirement Arrangement, which is a type of tax-advantaged account that helps you save more for the future than you could using a regular, taxable brokerage account. You choose investments from a menu of options and your account value fluctuates based on their performance.
With a traditional IRA contributions are tax-deductible, which means you don’t have to pay taxes on them in the current year. For example, if you earn $75,000 and contribute $5,000 to a traditional IRA, you only have to pay tax on $70,000 of income.
Taxes on your contributions and their earnings are deferred in a traditional IRA until you make withdrawals at some future date. So it’s a great option when you need a tax break or believe that your tax rate is higher today than it’s likely to be in retirement.
With a Roth IRA contributions are not tax-deductible, which means you do have to pay tax upfront. Using the same example, if you earn $75,000 and contribute $5,000 to a Roth IRA, you have to pay tax on $75,000.
However, what’s so powerful about a Roth is that both your contributions and earnings can be withdrawn completely tax free when you retire. You avoid paying tax on years or decades of growth in the account—that’s a fantastic benefit!
A Roth is a smart option if you believe that your tax rate is lower today than it’s likely to be in the future. That’s probably the case if you’re just starting your career and are earning less now than you will down the road. The idea is that paying tax at a lower rate now, instead of at a potentially higher rate in the future, saves money.
See also: 6 FAQs About Roth Retirement Accounts