Using a Roth IRA for College Savings

in Financial Planning-RSS, Personal Finance Essentials by

As college tuition and associated costs continue to dramatically rise, people are looking for more creative ways to save for these large expenses.

One option: leveraging a Roth IRA.

It might seem unusual using what is typically a retirement account to save for education expenses. But under the right financial circumstances, a Roth IRA can offer unique tax benefits and unparalleled flexibility that other college saving vehicles cannot.

While you can also use a traditional IRA, they tend to be a little bit trickier. Traditional IRAs do offer a penalty-free withdrawal, but only if the withdrawal occurs in the same year as the qualified education expenses are paid. Otherwise, you’re subject to a 10% penalty. Roth IRA contributions, on the other hand, can be withdrawn penalty and tax-free regardless of the use of the funds.

Remember, make sure you’re on the right track to meet your retirement goals before contributing to any education goals. Saving for college usually should take a backseat to saving for retirement. You can borrow money for college, but you can’t for your retirement.

Three Benefits to Leveraging a Roth IRA for College Savings

Here are three reasons why using a Roth IRA for education savings might be useful for some families:

  1. Roth IRAs aren’t included as an asset on the FAFSA Form
  2. If your child wants to apply for financial aid, they have to file a form called the Free Application for Federal Student Aid (FAFSA). Through a series of over 100 questions, the form is designed to help calculate your expected family contribution (EFC), which is essentially the amount they think a person should pay for their own education based on the assets of the student and their parents. On a FAFSA, a 529 plan is included as an asset and can increase your EFC, which decreases the amount of financial aid your child would otherwise qualify for.

    Roth IRAs — as well as other retirement accounts — aren’t considered assets when determining a family’s EFC. What’s more, there’s no cap to that amount, so you can accumulate pretty significant sums in your Roth IRA and still qualify for student aid.

  3. Roth IRAs are more flexible
  4. A Roth IRA may be beneficial if you’re unsure your child will attend college or if you want to maintain monetary flexibility. What’s great about a Roth IRA is that you can save money now and decide what you want to use it for later. For example, if your retirement is on track through other accounts, you can use the funds for your child’s education. If not, you just keep the money in the Roth IRA.

    Roth IRAs are a solid education savings option for anyone eligible to contribute because not only can it be used to supplement retirement, but also can be passed on to heirs. Additionally, there is no required minimum distribution (RMD) on Roth IRAs – which is the minimum amount you must withdraw from your account each year. That means funds can be held much longer than in traditional IRAs.

  5. Roth IRAs may provide the same tax-free treatment for distributions
  6. These accounts are tax-exempt, which means money is contributed after tax, but earnings and dividends accrue tax-free (though they are subject to a 10% penalty for early withdrawal). For the account holder to avoid penalties, the account holder must satisfy two requirements. First, the Roth IRA must have been established at least five years before the first withdrawal. Second, you must be at least 59½. Keep in mind, there are investment and income limits to a Roth IRA.

Three Drawbacks of Using a Roth IRA to Save for College

As with anything, there are some downsides to using a Roth IRA to help finance Junior’s college. We’ve outlined a few of the challenges to this strategy:

  1. Contribution Limits
  2. Comparatively to other college savings vehicles, Roth IRAs have lower contribution limits. Roth IRA contribution limits are significantly lower than the higher limits found with 529 college savings plans. For 2017, your total contributions to all of your traditional and Roth IRAs cannot be more than $5,500 ($6,500 if you’re age 50 or older), or your taxable compensation for the year, if your compensation was less than the contribution limit ($5,500). Conversely, many states’ 529 plans allow for rather high contributions — in some cases over $400,000.

  3. You Need Earnings to Participate
  4. This eliminates the possibility for many retirees to participate. To contribute to a Roth IRA, an “earned income” in the year you want to make a contribution is required. This means you must have an income — which includes wages, salaries, tips, bonuses, commissions and self-employment income.

    Additional earned income that counts toward eligibility includes taxable alimony and military differential pay. Things like interest and dividends from investments, income from rental property, and pension payments are not included in determining your eligibility.

  5. People with High Incomes are Prohibited from Participating
  6. Roth IRAs have income limitations. Married couples who earn more than $194,000 and file joint returns ($133,000 for singles) are ineligible for to contribute directly to these accounts.

Our Takeaway

IRAs offer greater flexibility when saving for college — you maintain full control over the underlying investments. But this also means they require greater responsibility and may not be ideal for “hands-off” investors, which means you would be in charge of monitoring and maintaining the portfolio allocation over time. Time is important to consider as well – the longer expected time horizon for the tax-free growth of Roth IRA assets usually outweighs the shorter expected time horizon for the tax-free growth of 529 assets. This can have a big impact over time and should be considered when establishing your saving goals.

A 529 plan might make more sense for some since the Roth IRA contribution limit is oftentimes not enough to meet both retirement and education funding goals. 529 plans have dramatically higher contribution limit caps, allowing families to save a bit more. Income limitations might also prevent people from contributing to a Roth IRA in the first place.

Again, we caution anyone against using too much (if any) of your retirement savings to fund a college education. Nevertheless, depending on your unique financial situation, using a 529 plan as your primary college savings vehicle and keeping money in a Roth IRA as a backup might be the best option for you. Schedule time with an advisor to discuss which option is best for you

Try our new feature on the dashbaord: Education Planner

For a video demonstration, click here.

This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, Personal Capital cannot guarantee that data’s currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

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Jacob Collinsworth

Jacob Collinsworth

Jacob Collinsworth is a Research Associate on the Portfolio Management team at Personal Capital. He trades client accounts on a daily basis and helps support the Advisory Team. Prior to joining Personal Capital, he worked with the Private Client Group at Fidelity Investments and graduated with a Master's in Business Administration from the University of North Florida.
Jacob Collinsworth

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2 comments

  1. Daniel

    Hi Jacob, thanks for the article. I do have a question related to the Roth IRA’s. At the end of the article, you mention that “People with High Incomes are Prohibited from Participating” in Roth IRA’s, however, I’ve been reading about using the “backdoor” method to fund Roth IRA’s even if the AGI is higher than the limits set to contribute directly. In our case, we can’t contribute directly to a Roth IRA or get tax advantages in contributing to Trad IRA’s, so, does it make sense to contribute the maximum amount to a Trad IRA where we would be contributing after-tax money and then converting the full amount to Roth IRA? and, if we were to do that the first year, can we continue doing that the following years assuming rules don’t change?

    Reply
    • Jennifer Kincaid

      Hi Daniel – thanks for reading! This process is called a “back-door Roth contribution” and is currently allowed by the IRS with no real limitations. It can certainly be a benefit in the long term and is allowed in any tax year (assuming no policy changes) but one must take care in pursuing this. The IRS has an IRA aggregation rule that could mean hefty taxes upon converting to the Roth if you currently have any tax-deferred IRA assets. As an example, if you were to make a non-deductible contribution to a traditional IRA and then convert to the Roth, you might assume no taxes would be due since you did not originally deduct the contribution. However, the IRS lumps all of your IRA assets into one bucket and will calculate a ratio of tax-deferred assets compared to tax-free assets when determining the tax implications of conversions. This means some of the conversion amount could be considered taxable. There are some ways to mitigate this but it’s usually best to speak to a financial advisor to make sure this is executed effectively.

      Reply

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Disclaimer. This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data's currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.