If you are looking to set money aside for your child or grandchild’s education you are likely considering a 529 plan, a custodial account, or possibly a trust. Each of those accounts have positive and negative qualities, but there is another option for college savings that is a bit unconventional – a Roth IRA.
I am a big fan of Roths and I have previously written how individuals over the income limit can fund an account annually via a backdoor contribution. Roths offer tax-free growth, virtually unlimited investment options, and tax-free withdrawals if you are over age 59.5. Nine times out ten they are used during retirement, but Roths have some positive attributes that the previously mentioned accounts do not, which may make them an interesting choice for your loved one’s education.
Additional Pros of Roth IRAs for College Savings
- Flexibility – The accounts I mentioned in the opening paragraph are all earmarked for a beneficiary, but a Roth IRA is a retirement account for you. If your budget is tight and you need to prioritize saving for your retirement instead of 529 contributions a Roth could be viable. Perhaps funding your child’s education is towards the bottom of your financial goals or if you believe they will receive a scholarship or not attend college altogether; a Roth gives you optionality that other accounts lack. You can put money aside now and decide how it will be used down the road.
- Avoid penalties – You may be thinking “aren’t there penalties if you withdraw funds from a retirement account early?” Typically there are, however, withdrawal penalties are waived if the funds are used specifically for qualified educational expenses including tuition, fees, books and room and board. Additionally, Roth’s have unique tax treatment where the account holder can always withdraw their contributions to the account, as long as the account has been open for five years, without penalties. If you contributed $50,000 to a Roth IRA over the past ten years and the account is now worth $100,000, you can withdraw up to $50,000 for whatever reason penalty free.
- Financial aid – 529s and custodial accounts, as well as, non-retirement assets of the parent have to be disclosed when filling out the FAFSA. Roth IRA’s and other retirement accounts are not used to determine the expected family contribution (EFC) making it easier to qualify for financial aid. There is a caveat. Withdrawals from retirement accounts are counted as income on the FAFSA so proper planning is necessary in order to maintain your child’s financial aid.
- Contribution limitations – Your annual contribution to any IRA is limited to $5,500 if you are under 50 and $6,500 if you are 50+. Assuming maximum funding for eighteen years, your Roth would contributions would total $99,000 and if your spouse maxes out your contributions would be double. Those are not insignificant amounts, but contribution limits for other education savings accounts are significantly greater. Additionally, you are restricted from contributing to a Roth if you earn too much. The income phase out for a married couple is $189,000 – $199,000 and $120,000 – $135,000 for a single or head of household filers. You may be able to utilize the backdoor strategy, but it does not work for everyone.
- Hindering retirement – Paying for college should NEVER come at the expense of your own financial stability and retirement. A Roth IRA can be a very valuable piece of your retirement savings plan and depleting it for a child’s education is not wise if other goals are not on solid footing. There are other ways to pay for college, but few ways to fund a secure retirement.
- Potential taxation on earnings – As mentioned earlier you can withdraw funds from a Roth without penalty if the proceeds are used for education expenses. However, if you are under age 59.5, any earnings or appreciation withdrawn from the account will be taxable as income. This is less than ideal as earnings within 529 accounts can be withdrawn tax-free if they are used for qualified education expenses. This rule makes Roths for education for viable if you have children later in life or if you are a grandparent.
Clearly this post does not advocate that you absolutely should use a Roth IRA to save for your loved one’s education. In the majority of situations a 529 plan or a brokerage account will be your best option. But under the right personal fact pattern a Roth IRA could play a role in your education savings plan.