Using Roth IRAs for college savings

Are you currently saving for your child’s college education? If so, you may be using one of the most recommended tax-favored vehicles for accumulating and paying out dollars for college expenses — a Section 529 college savings plan. But there is another option that is beginning to garner more and more attention to achieve the same purpose — tax-favored savings, and that would be a Roth IRA. But, Roth IRAs are for retirement you say, and you would be correct. However, this “retirement” savings plan can also provide interesting alternative advantages for college savings in addition to its well-defined tax-free accumulation (assuming you satisfy certain requirements).

It is well known that Section 529 savings plans permit the tax-free accumulation and distribution of education savings as long as those distributions are for qualified education expenses, such as tuition, room and board, computers, etc. For that reason alone, these plans have increased in popularity during the last decade. But, distributions for any other reason are treated harshly for tax purposes, ie, the earnings are taxable as ordinary income and subject to a 10% penalty. What if, for instance, the child for whom the savings have been accumulated does not go to college? Although Section 529 plan accumulations can be transferred to another student, there is not always another student in line for them.

Section 529 plans are also not infallible for another reason — accumulations inside these vehicles may, in fact, reduce the availability of financial aid, as Section 529 assets are considered ‘available assets’ when calculating the expected family contribution (EFC) on the Free Application for Federal Student Aid (FAFSA) form. In other words, accumulating significant savings inside a Section 529 plan for a college-bound student may, in fact, reduce the amount of eligible financial aid for that student. This does not make Section 529 Plans a bad option; it is just one limitation on the usefulness of Section 529 savings plans of which many people are not aware.

Kenneth W. Rudzinski

Kenneth W. Rudzinski

But accumulations within Roth IRAs, as well as other retirement vehicles, are not counted as assets for the EFC calculation. Granted, they do have certain limitations, such as annual contribution limits of $5,500 for savers under age 50 and $6,500 for those age 50 or older. Also, eligibility to fund a Roth IRA in the current year is subject to certain IRS income limits (see Table), so not everyone can fund a Roth IRA for either education or retirement. Those aside, a Roth IRA may be an effective partner to, and not necessarily a replacement of, a Section 529 savings plan.

Minimum savings window

To receive the most-favored tax treatment — that is, tax-free growth and tax-free distributions — Roth IRAs require a 5-year minimum savings window, or to age 59.5, if later. So, if your child’s college education needs occur after you are age 59.5 (assuming 5-years of accumulation), then withdrawals from the Roth IRA can be made tax-free, similar to the Section 529 plan. But, what if your child’s need for the money occurs prior to your being age 59.5, or before the 5-year minimum period? In that case, you are permitted to withdraw all of your contributions tax-free and allow the gain to continue to grow tax-free. This rule applies to all Roth IRA withdrawals, as long as any Roth IRA you own has satisfied the 5-year/age 59.5 rule, including amounts in a prior ROTH conversion. See below for an alternative strategy for pre-age 59.5 withdrawals.

Roth Table 1 

How does all this make a Roth IRA a viable alternative to Section 529 savings plans? One very good reason: How does anyone know whether a young child will in fact be college material 10, 12, 18 years from now? We don’t. So, although Section 529 plans are transferable, the last child in a family, for whom Section 529 assets have been accumulating the longest, may not be college-bound. To recover those assets for yourself, you face the onerous tax consequences cited earlier, ie, income tax on the gain plus a 0% penalty. If, on the other hand, assets intended for college education had alternatively or instead been accumulating in a Roth IRA in this same situation, you can continue the Roth IRA savings for your own retirement. This is the second major advantage of using a Roth IRA to fund a college education savings plan. It can remain part of your own retirement savings if not needed for education funding.

Alternate use of funds

If you are younger than 59.5 when the funds are needed for your son’s or daughter’s college expenses, instead of immediately using your Roth IRA (by withdrawing only your contributions tax-free), you could alternatively use student loans to fund those expenses and then make later withdrawals from the Roth IRA to pay back the loans, using withdrawals of contributions before age 59.5 and gains after age 59.5.

So, when deciding how to fund for college education expenses, if you are eligible to fund a Roth IRA, think about adding one as a partner to a Section 529 savings plan. Both have built-in advantages and disadvantages as we have seen. It is the combination of the two that may be the best tax-wise way to accumulate dollars for your children’s or grandchildren’s college educations. In the final analysis, every family situation is different; therefore, you should evaluate all options to arrive at what is best for you.

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