Using a Roth IRA as a College Savings Tool

A Tax-Advantaged Option too Many Families Overlook

By PAUL TAGHIBAGI | Special to the Palisadian-Post

At first glance, a Roth IRA might seem an unusual college savings vehicle. Upon further examination, it may look like a particularly smart choice.

A Roth IRA allows you to save for college without the constraints of a college fund. This is an important distinction, because you cannot predict everything about your child’s educational future.

What if you contribute to a 529 plan or a Coverdell ESA, and then your child decides not to go to college? Or, what if you save for years through one of these plans, with the goal of paying tuition at an elite school, and then a great university steps forward to offer your child a major scholarship or a full ride?

If you take funds out of a Coverdell ESA or 529 college savings plan and use them for anything but qualified education expenses, an income tax bill will result, plus a 10 percent Internal Revenue Service penalty on account earnings. (The 10 percent penalty is waived for 529 plan beneficiaries who get scholarships.)

You gain flexibility when you save for college using a Roth IRA. If your child gets a scholarship, elects not to attend college or goes to a less expensive college than you anticipated, you still have an invested, tax-advantaged account left to use for your retirement, with the potential to withdraw 100 percent of it, tax free.

You can withdraw Roth IRA contributions at any time and for any reason without incurring taxes or penalties. When you are an original owner of a Roth IRA and you are age 59-and-a-half or older, you can withdraw your Roth IRA’s earnings tax-free, so long as the IRA has existed for five years.

From a college savings standpoint, all this is great: Parents 60 and older who have owned a Roth for at least five years may draw it down without any of that money being taxed, and younger parents may withdraw at least part of the money in a Roth IRA, tax free.

You probably know that the IRS discourages withdrawals of Roth IRA earnings before age 59-and-a-half with a 10 percent early withdrawal penalty. This penalty is not assessed, however, if the early withdrawal is used for qualified higher education expenses. Occasionally, parents roll over money from workplace retirement plans into Roth IRAs to take advantage of this exemption.

With a Roth IRA, your investment options are broad. In contrast, many 529 college savings plans give you only limited investment choices.

Admittedly, a Roth IRA is not a perfect college savings vehicle. It has some drawbacks and the big one is the annual contribution limit. You can currently contribute up to $5,500 to a Roth IRA per year, $6,500 per year if you are 50 or older. That pales next to the limits for 529 college savings plans.

Some families earn too much money to open a Roth IRA. Joint filers, for example, cannot contribute to a Roth if they make in excess of $198,999 in 2018. There is a potential move around this obstacle: the so-called “backdoor Roth IRA.”

You create a “backdoor Roth IRA” by rolling over assets from a traditional IRA into a Roth. That action has tax consequences, and once the rollover is made, you are prohibited from putting the assets back into the traditional IRA.

Lastly, there is a bit of an impact on financial aid prospects. When funds are distributed from a Roth IRA and used to pay for college costs, those distributions are defined as untaxed income on the Free Application for Federal Student Aid (FAFSA). Fortunately, the total asset value of the Roth IRA is not reported on the FAFSA.

Roth IRAs may help families who want to save for retirement and college. If you already have a good start on retirement savings and want to open one with the intention of using it as a college fund, it may be a superb idea.

If you like the potential of having tax-free retirement income and may need a little more college funding for your kids, it may be a good idea as well. Talk to a financial professional to see how well it might fit in your overall financial or retirement strategy.

Paul Taghibagi may be reached at 310-712-2323, pt@seia.com or seia.com/bio/paul-taghibagi.