Many parents start stressing about the affordability of college well before application time. Given the steady rise of college expenses, some parents start saving as early as infancy.
If you’re worried about saving enough for college, there are several different planning strategies you could implement as part of your overall plan to pay for your child’s college education. A 529 College Saving plan is one of the most popular tools, but it’s not the only option.
One often overlooked way to help save and pay for tuition is to use your Roth IRA retirement account as a college savings account.
Why would someone tap a retirement account to save for college? Because there are some unique advantages:
- You can withdraw without penalty or taxes before retirement
- The balance isn't counted against you when determining financial aid
- The money is still yours, without penalty, if your child doesn’t go to college
You should consult a tax professional before making any decisions about utilizing a retirement fund to save for college. Also keep in mind that tax laws and loopholes can always change between now and when your child will be attending college, so saving exclusively in a Roth IRA is probably not your best strategy.
1. Financial benefits of Roth IRA accounts
Roth IRA accounts offer a rare break from the usual tax disadvantages of withdrawing from other assets and savings accounts. According to Scott Hanson with CNBC, “Roth IRAs enjoy a rather unique tax treatment. Withdrawals are treated as a ‘return of contribution’ first and as earnings second.”
What this means is that you are always allowed to withdraw from your Roth IRA, tax and penalty free, up to the amount that you have contributed. For example, if you have saved the maximum allowable amount (usually $5, 500) into your account for 5 years, you will be able to withdraw $27,500 without penalty. Having access to that amount of money, penalty free, is enormously beneficial for helping to pay for the rising costs of college.
2. Roth IRA accounts aren’t considered for FAFSA
Any student looking to receive federal aid for their higher education costs needs to fill out the Free Application for Federal Student Aid Form (FAFSA). FAFSA will assess your child’s ability to pay, including the Expected Family Contribution (EFC). The EFC takes all of your family’s income, savings, and benefits into account for deciding the level of financial aid necessary for your child’s college education.
This is where Roth IRA accounts become a valuable asset as part of your overall college saving plan. When you report all of your assets on the FAFSA application form, 529 College Saving Plans also have to be reported as part of your overall income. This means that you will actually be penalized for saving into a 529 account, and you won’t receive as much financial aid as you could have, had you not done your due diligence by saving for your child’s college education.
3. It can be used if your child decides not to go to college
At the end of the day, a Roth IRA is still a retirement savings vehicle. No matter whether you choose distribute the funds for other purposes or not, it will always be there to use during retirement. There won’t be any fees or penalties for re-designating the account’s purpose.
If however, you choose to save all of your money for your child’s college fund into a 529 account, you will end up facing severe tax penalties to withdraw or transfer that money for a non-education related reason if you child ends up not attending school.
By taking a non-qualifying distribution, you would likely pay a 10% penalty on the earnings as well as have to pay taxes on the distributions.
Disadvantages of using a Roth IRA
Please note that while Roth IRA’s are not included as part of your taxable income on the FAFSA, any amount that you do withdraw this year from your account will be considered as taxable income on the next year’s form. For example, if you decide to withdraw from your IRA to pay for child’s dorm living costs instead of getting a loan, when you fill out the FAFSA form for their sophomore year, you may be denied as much aid as you received the year before, since you technically had an increase in income when you had access to the money from your account.
One loophole to employ as a method to bypass that penalty is to wait to withdraw any money from your Roth IRA account until after you have filled out the FAFSA for your child’s last year of college. You could have your child take out loans for the interim and then withdraw from your accounts once they finish school to help pay off those loans. Even if you are not yet the required 59 ½ years old to pull money from the account penalty free, the usual 10% penalty fined for early withdrawals from your account will be waived for any college related expenses.
Also, as a parenting bonus, it’s a helpful method for ensuring that your child does graduate, because they will know that you won’t help them pay back their school loans until after they’re finished.
Can Anyone Use the Roth IRA?
The IRS does have income limitations for who is eligible for a Roth IRA. The chart below from IRS.gov outlines income limitations from the IRS.
Married parents filing jointly who more than $193,000 are not eligible to contribute to a Roth IRA. Single parents who earn more than $131,000 are also ineligible. In these cases, a 529 Plan may be the best course of action when saving for college.
A Roth IRA is good for diversifying your payment methods
A Roth IRA can be just one part of a healthy retirement and college planning strategy. Having penalty free access to your account is just one beneficial way to save for college, but it shouldn’t be your only way to pay for the rising costs of college.
Also, while using a Roth IRA as a college savings account has its merits, I absolutely caution against using the entirety of your retirement savings account to pay for your child’s college education. Your child will always be able to get a school loan, but you won’t have forever to save for your retirement living expenses.
Only use your Roth IRA as a college savings account if you have access to other retirement funds for your actual retirement expenses. Take care to not let your college saving plan negatively affect your own ability to live and save money for retirement.
Kristi Muse of Moderate Muse