Roth IRA: Unique Way to Save for College

The Roth IRA: A Unique Way to Save for College

Saving for your child's college education may have been on your mind since before your baby was even in the womb. It's certainly one of the biggest financial burdens parents encounter. While there's no set rule stating you must pay for college, it's understandable why parents want to help. The big question is: what's the best way to save? Sure, there are several products marketed specifically toward saving for college, but there's a secret weapon you may be unaware of: the Roth IRA.

How You Can Use the Roth IRA to Pay for College

To understand how a Roth IRA can be used to pay for college expenses, you must first understand how one works. A Roth IRA is funded with a maximum of $5,500 annually in post-tax dollars, and there are income limits that vary based on your filing status. Traditional IRAs are funded with pre-tax dollars to give you a deduction in the current tax year, but you pay a tax on withdrawals in the future. You also can't withdraw those funds without a paying a penalty until you're 59 ½ years old. Because the Roth IRA is funded with money that's already been taxed, it means you can take a withdrawal from your contributions both tax- and penalty-free for any reason before you're 59 ½ years old. You just need to have allowed at least five years to pass since your first contribution.

In most cases, you can only withdraw your contributions — not the earnings on those contributions — to avoid a tax penalty. One exception allows withdrawals on earnings before you reach 59 ½ for qualifying education expenses. This won't trigger a penalty, but you may have to pay income taxes on the money you withdraw.

Since a Roth IRA is also a retirement account, it is not required on the Free Application for Federal Student Aid (FAFSA) and won't be factored into your child's eligibility for financial aid. Unlike other college savings plans, you aren't going to pay a penalty either if you withdraw your contributions and use the funds for non-educational expenses.

Here are other ways that parents save for college costs. Compare these against the Roth IRA for help deciding how to save for college.

Three Common College Savings Plans

1. The 529 Savings Plan is one of the most common ways to save for college. It is often offered by state governments, but you aren't required to use your state's plan. A 529 Plan is a tax-advantaged account that doesn't lower your taxable income now because it's funded with post-tax dollars. The perk, however, is that the earnings aren't subject to federal tax and typically states don't tax them either. Still, you must use the money for qualifying educational expenses. Otherwise, you may face a penalty.

That's where a Roth IRA trumps the 529: your remaining funds are for retirement and there won't be a tax penalty. The 529, however, does beat the Roth IRA in maximum contributions, which is $14,000 (or $28,000 for a married couple).

2. A Coverdell Education Savings Account (ESA) can be used to fund qualifying education expenses of a designated beneficiary who must be under the age of 18 when the account is both created and funded. Thus, contributions to the Coverdell must stop when the beneficiary reaches 18. The Roth IRA allows you to keep contributing throughout college, so there's no hard cut off like with the Coverdell. Contributions to the Coverdell are not tax deductible, but distributions can generally be taken out tax free.

The perk of a Coverdell ESA for parents is that funds can be used not only for college, but also for primary and secondary education expenses. However, the contribution maximums are small at $2,000, and you may also pay a 10 percent additional tax penalty if you take a distribution that isn't for qualifying educational expenses. If your child receives a scholarship or attends a military academy, however, you could be able to take a distribution penalty free.

3. The Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) both offer minor students ways to own or be given property, securities or gifts through custodial accounts. Some parents, grandparents or other adults use these accounts to put aside money for a child with college in mind. The issue is that at a certain age (18 to 21 in most states, but the account opener can specify), the child fully controls the account.

Should the child elect to take the money and finance their best friend's startup instead of college, the parent has no leverage. That would never be an issue with a Roth IRA as you'd always be in control of the funds. You may also be doing your child a disservice when it comes to FAFSA, because custodial accounts are considered a student asset and could reduce their financial aid eligibility.

The Roth IRA Is A Unique Tool, When Used Correctly

  • The Roth IRA isn't required to be reported on the FAFSA, so it doesn't impact financial aid eligibility.
  • You're always in control, which is a big perk compared to custodial accounts that you hand over to a child once they hit the age of majority.
  • You can continue making contributions throughout your children's college careers (and after). Plus, all the unused sums go to retirement, so you won't incur penalties after you're 59 ½.
  • The downside, however, is that the contribution limits are low compared to the 529 Plan and you could be tempted to deplete your own retirement savings to send your child to college.

To effectively use the Roth IRA as a college savings tool, it's key to have other retirement savings. Your child can take out student loans to pay for college, but you don't have the same luxury to fund retirement.

We encourage you to consult a financial planner when comparing retirement and savings accounts. You can also consult a tax professional for tax advice. Please also see Publication 590-A and IRS Publication 970 for more information, or call the IRS at 1-800-829-1040 (TTY 1-800-829-4059).