Graduate Students, Roth IRAs, and 529 Plans

||  This article is part of a series on the 529 Education Savings Plan  ||

In school? You have options! (X1)
It is a shame that graduate students - a group who could very much use the opportunity to avoid falling behind their better-paid peers in saving and investing - are very often ineligible to contribute to a Roth IRA.

However, all is not lost!  Some graduate students are made eligible by other sources of income, and all graduate students can engineer around the problem with another qualified savings and investment option: the 529 Plan.

Earned Income

As mentioned in my Roth IRA Introduction, you must have 'earned income' to be eligible to contribute.  The source of confusion is in the definition: counterintuitively, not all taxable income is considered earned income.  If you are paid on a scholarship, fellowship, or grant and you aren't issued Form W-2 at tax time, you're out of luck: your earnings aren't technically 'earned'.  There has been some controversy about this online, but IRS Publication 590 on Individual Retirement Arrangements makes it pretty clear (1):

"Wages, salaries, tips, professional fees, bonuses, and other amounts you receive for providing personal services are compensation. The IRS treats as compensation any amount properly shown in box 1 (Wages, tips, other compensation) of Form W-2, Wage and Tax Statement, provided that amount is reduced by any amount properly shown in box 11 (Nonqualified plans). Scholarship and fellowship payments are compensation for IRA purposes only if shown in box 1 of Form W-2."

This has a number of consequences for scholarship and fellowship holders:
  1. Payroll taxes, which are usually 7.65% from both the employee and the employer, aren't levied
  2. Graduate students do not accumulate Social Security eligibility points
  3. No income taxes whatsoever are withheld
  4. You must have other income that generates a Form W-2 to contribute to an IRA 
If your funding source does issue you a Form W-2, you can contribute freely to a Roth IRA.  Open an account with Vanguard or your brokerage of choice and get in there!

The 529 Plan Alternative

The 529 Education Savings Plan is an investment vehicle that provides Roth IRA-like tax advantages for those saving to pay higher education expenses.  A custodian invests post-tax money in the account for a beneficiary to withdraw tax-free to pay for qualified educational expenses, which include tuition, fees, required books and equipment, rent, utilities, and food.  The custodian and the beneficiary may be the same person: you can open a 529 Plan for yourself.

Annual contributions are almost unlimited: gift tax laws are usually triggered for gifts to a single person of over $17,000 per year, but a special gift tax exclusion allows a custodian to use up five years' worth of gift tax exclusions in a single year's $65,000 contribution.  If you are both the custodian and the beneficiary of your plan, the gift tax exclusion limit is irrelevant.  A single 529 Plan account will only take additional contributions until it reaches $320,000-370,000 in assets, but anyone is free to open multiple accounts.  Each state offers its own slightly-different 529 Plan, and a resident of any state may open one or more 529 Plan accounts in any number of other states.  A few states try to entice their residents to invest with them by offering state tax deductions for contributions.  The state a beneficiary attends school in has no bearing on their eligibility to use a given state's plan.

Once inside a 529 Plan, money is invested in 'Portfolios' that hold some other asset; in Vanguard's Nevada-sponsored 529 Plan, for instance, you can invest in portfolios that hold Vanguard's low-cost index mutual funds (2).  

So, here's an account with almost no contribution restrictions and the same underlying investments as a Roth IRA, but with tax-free distributions for education instead of retirement.  How might the graduate student who cannot contribute to a Roth IRA take advantage of this?

First: a graduate student can use a 529 Plan as a potentially extraordinarily high-yield savings account to store their emergency funds.  By investing in the Vanguard Conservative Growth Portfolio (75% bonds, 17.5% domestic stock, 7.5% international stock), a student can limit the probability of significant short-term losses over the timeframe they're in school while maintaining exposure to the stock and bond markets.  If they need the money, they can withdraw up to the value of their total higher education expenses for the year - including rent, utilities, and food - without triggering any taxes or penalties.  A withdrawal will generate a Form 1099Q, and you should keep a simple record of your expenses so that you can qualify the withdrawal if the IRS ever audits you.

Second: the 529 Plan can stand in directly for a Roth IRA, if you aren't able to contribute to one or you already max out your IRA contributions.  529 Plan contributions can be invested in volatile, high-yield-potential stock index funds via the Vanguard Aggressive Growth Portfolio (70% domestic stock, 30% international stock).  As your final year of graduate school approaches, you have options:
  1. Withdraw much more than you need (still staying within your annual qualified educational expenses) as cash with the intention of reinvesting it in a Roth IRA or company retirement plan as soon as you get a job
  2. Leave the money in the plan to cover future higher education expenses for yourself, your potential future kids, or anyone else related to you
You'll be eligible for Roth IRA contributions on the year when you get some earned income in your new job, so you can use this opportunity to offload 529 Plan money more-or-less directly (though still subject to the annual contribution limits) into a Roth IRA without any tax consequences.  Keep in mind that you can only make tax-free 529 Plan withdrawals on the calendar year that you're still in school, so plan accordingly.

Your own medical, law, or business school expenses down the line can be covered with 529 Plan money, or you can transfer your plan to another family member.  For more specifics, see IRS Publication 970 - 'Tax Benefits for Education' (3) and my Investment Guide entry on 529 Plans.


Though the earned income requirement and the curious characterization of scholarship, grant, and fellowship income may keep many graduate students from funding a Roth IRA while they're still in school, the 529 Plan can serve as a tax-advantaged, market-exposed bridge until you begin working and the assets can be transferred into a Roth IRA and employer retirement accounts.  If you already max out your Roth IRA contributions, the 529 Plan is another tax-advantaged place to begin investing for the future.

(1) IRS Publication 590: Individual Retirement Arrangements - http://www.irs.gov/publications/p590/
(2) Vanguard 529 Portfolios - https://personal.vanguard.com/us/funds/529portfolios/byname
Do note that the expense ratios for these portfolios are slightly higher than those for the underlying mutual funds: a portfolio holding VSTMX sets you back 0.25%, whereas VSTMX itself has an expense ratio of 0.16% (0.08% if you have over $10k in it).  Along these lines, the Vanguard Aggressive Growth Portfolio (70% VTSMX domestic, 30% VGTSX international, ER 0.25%) is still a very good deal.
(3) IRS Publication 970, Tax Benefits for Education - http://www.irs.gov/publications/p970/ch08.html
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