Mutual Funds vs. Roth IRA for College

by Mike Parker

The cost of gaining a college education is high and is expected to get higher. The average in-state tuition for public colleges was $7,605 per year as of 2010, according to the College Board. Annual tuition at private four-year colleges averaged $27,293. The College Board notes that most students rely on some form of financial aid to help pay for their college expense, but most students are still responsible for paying at least some portion of their college education. You can save money for your college years in a variety of places, including mutual funds and individual retirement accounts.

Mutual Funds

You can save for college by setting aside funds in a mutual fund. A mutual fund is a pooled investment. This means a company gathers money from many investors, pools all of those funds together and purchases a portfolio of securities. All of the investors own a pro rata share of all of the securities in the mutual fund. A mutual fund gives you the two important benefits of diversification of your investments and professional management of your assets.

Risks and Rewards

You can make money on your mutual funds in three primary ways. The securities inside your mutual fund may pay interest or dividends. Securities trades inside your mutual fund may generate capital gains. The value of the securities in your mutual fund may increase in value, resulting in an increase of the net asset value, or share price, of your mutual fund. There are also risks associated with mutual funds. The value of the securities in your mutual fund may decrease, resulting in a decrease in the net asset value of your mutual fund. Mutual funds are not insured by the Federal Deposit Insurance Corporation or any other federal agency, even if the securities inside the mutual fund are insured. Any taxable income produced in the mutual will be passed on to you on a pro rata basis.

Individual Retirement Accounts

Individual retirement accounts (IRAs) were created to allow working taxpayers with a means of setting aside a portion of their earnings in a tax-advantaged account to help supplement their retirement income. Funds in an IRA are allowed to grow tax deferred until they are withdrawn. This can be a substantial benefit if your are saving for college, because more of your money is working for you. Another significant benefit is that an IRA is a type of holding account, not an investment. You must fund your IRA with cash or cash equivalents, but you can purchase a wide variety of investments with the money in your IRA, including the same mutual funds you would buy to save for college. All of the earnings from the mutual fund would be tax deferred, giving you more money to work with.

Tax Penalties

There is a reason these accounts are called individual retirement accounts. Congress permitted the tax benefits of these accounts to encourage people to save for their retirement years. You have to leave your money in your traditional IRA until you are 59 1/2 before you can take penalty-free withdrawals from the account. You can withdraw the contribution portion of your Roth IRA at any time without creating a taxable event, but the earnings on a Roth IRA must remain in the account for at least five years before you can take a penalty-free withdrawal. The tax penalty for an early withdrawal from either type of IRA is 10 percent of the non-qualified amount withdrawn.

IRA Education Withdrawal

Internal Revenue Service (IRS) regulations makes an exception to the tax penalty rule for early withdrawals from your IRA if you use the funds to pay for qualified higher education expenses. These expenses include tuition, supplies, equipment, fees and books the college requires for either for enrollment or attendance. The relief from the tax penalty applies to college expenses for you, your spouse, your children and your descendants. Keep in mind that even though you avoid paying the tax penalty, you will still be liable for paying ordinary income taxes on the non-qualified amount withdrawn.

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