Two Savings Options to Consider
A Section 529 plan is a tax-advantaged education savings plan typically sponsored by a state. Earnings grow free of federal income tax, and withdrawals generally are federal-income-tax-free when used for qualified education expenses. It can be an attractive option for families looking to set aside funds specifically for education.A custodial Roth IRA offers a different approach. Established and managed by an adult for a minor with taxable compensation, it offers tax advantages along with greater flexibility in how the funds ultimately may be used. Even if you already have a 529 plan, a custodial Roth IRA may be worth considering as a complementary savings strategy
Understanding 529 Plans
With 529 plans, the basic federal tax rule is that there will be no taxes owed on investment earnings while the funds are in the plan, or when they’re distributed, as long as they’re used for qualified education expenses. Withdrawals will be tax-free if used to pay for:
- Qualified postsecondary school expenses, such as tuition, mandatory fees, books, supplies, computer equipment, software, internet service, generally room and board and credentialing expenses,
- Qualified K-12 school expenses of up to $20,000 (up from $10,000 before 2026) per year per beneficiary — such expenses now include not only tuition but also various other expenses such as books, instructional materials and certain fees, and
- Up to $10,000 of student loan debt per beneficiary.
Additionally, certain unused 529 funds may be rolled into a Roth IRA for the beneficiary if several requirements are met. These include a $35,000 lifetime rollover limit, annual Roth IRA contribution limits, earned income requirements for the beneficiary and a requirement that the 529 account generally must have been maintained for at least 15 years. Also, contributions and earnings from the previous five years generally can’t be rolled over.
529 plan distributions that are used for nonqualified purposes must be reported as taxable income, generally on the beneficiary’s federal income tax return. Taxable amounts are subject to income taxes and may trigger a 10% penalty unless an exception applies. Chances are that the child won’t be in a high tax bracket at that time, so the tax bill might not be terribly onerous. Still, it’s better to avoid taking that hit.Understanding Custodial Roth IRAs
You may already be familiar with the concept of a Roth IRA. A custodial Roth IRA is simply one established and managed by an adult (typically a parent or grandparent) for the benefit of a minor. When the child is no longer a minor, he or she assumes full control of the IRA. With a couple of exceptions, money taken out of a Roth IRA after age 59½ isn’t taxable, including withdrawals attributable to growth in the account.Early distributions (generally defined as those occurring before age 59½) from a Roth IRA are considered first to originate from the contributions to the plan and aren’t taxable or subject to early withdrawal penalties. Only early withdrawals in excess of contributions are subject to taxes and, potentially, penalties. That’s important when using a custodial Roth IRA as an education savings vehicle.
Suppose, for example, you’ve contributed $75,000 over the course of several years, and the value of the account has grown to $125,000. The IRA’s beneficiary could take out up to $75,000 to pay for college expenses without incurring a tax liability. The remaining $50,000 could continue to grow tax-free as long as those funds are left in the account. And, thanks to the Roth format, the funds could be withdrawn when the child reaches age 59½ without being taxed. Tax-free distributions are also allowed for account owners under 59½ if they’re permanently disabled or they use up to $10,000 for a first-time home purchase.
Comparing Contribution and Tax RulesAn important caveat about the custodial Roth IRA is that no more can be contributed to it in any year than the child has in earned income during that year. It’s the same rule that applies to all IRAs.
In 2026, the maximum annual contribution to an IRA is $7,500 for people under age 50. So, if the custodial Roth IRA beneficiary earns, for example, $4,000 in 2026, you could make a gift to the child in that amount to be used to fund the IRA. Of course, the child could also use some of his or her earnings to reach that $4,000 annual maximum and get an important early lesson in the value of a long-term savings plan.
By comparison, there are no federal tax-law limits on contributions to a 529 account. However, states sponsoring 529 plans generally do impose a limit, but typically not an annual one.
Whether you make gifts to a child to contribute to a Roth IRA or you contribute to a 529 plan, you’ll use up part of your unified federal gift and estate tax exemption if you make contributions above the gift tax annual exclusion, which is annually adjusted for inflation ($19,000 for 2026). (Under the annual exclusion, you also can exclude certain gifts of up to the annual exclusion amount — twice that per recipient if your spouse elects to split the gift with you — without using up any of your gift and estate tax exemption.) The lifetime exemption is $15 million for 2026. If you’re married, your spouse has a separate exemption.
Under an exception, you can frontload a 529 account by contributing up to five times the annual federal gift tax exclusion in the first year. This exception allows you to contribute up to $95,000 per beneficiary for 2026 without tapping into your gift and estate tax exemption. If you’re married, your spouse can do the same.
Important: States have their own tax rules for 529 plans. Depending on where you live, you may qualify for a state tax benefit. Many states offer either state income tax deductions or state income tax credits for 529 plan contributions. Tax benefits are typically available if you invest in your home state’s plan. However, some states offer tax benefits for contributions to other states’ plans. State plans may also set their own contribution limits. Contact a tax advisor for the applicable rules in your state.Choosing the Right Approach
In many cases, the best answer isn’t one or the other. A 529 plan may serve as the primary education savings vehicle, while a custodial Roth IRA may work as a complementary tool once the child has earned income. A 529 plan generally allows larger education-focused contributions. However, a custodial Roth IRA may provide greater flexibility if the child doesn’t need all the funds for education.Whatever education savings path you choose, look at the big picture. Besides tax considerations, it’s important to know whether your chosen strategy will affect the child’s eligibility for financial aid. Consult a tax or financial advisor to ensure you understand your options and have the information you need to make the best decision for your family.