6 reasons a Roth IRA may be best for saving for college

Could a Roth IRA be the best college savings vehicle?

A Roth IRA may be the best way to save for your kids college expenses

College expenses are increasing at a rapid pace. It’s safe to assume a 6.5% increase in the cost of college each year. This makes college incredibly difficult to save and plan for, and having the right plan in place very important!

It may seem odd, but a Roth IRA may be a great way to save for college expenses. It seems weird because the Roth IRA is just that – an individual retirement account. So why would you invest in a ROTH IRA to pay for college expenses?


6 reasons to use a Roth IRA for college savings

#1 Roth IRA’s aren’t reported on the FAFSA form. If your child needs financial aid, they must complete the Free Application for Federal Student Aid (FAFSA). It’s a very detailed form with 100+ mostly financial questions. It helps the government determine your need for financial help.

The form is used to calculate how much the family should contribute towards the students college expenses. This is called “the Expected Family Contribution” or EFC. Most of your assets including 529 plan accounts are required to be reported.

Roth IRA’s and other retirement accounts don’t have to be reported on the FAFSA form. If most of your assets are in a Roth IRA or other retirement accounts your expected family contribution may be reduced.

#2 Roth IRA’s are quite flexible. A 529 plan is meant to be used for qualified higher education expenses (QHEE’s). If they’re used properly the distributions are 100% tax free. Fail to use 529 plan funds for QHEE’s and you’ll pay a 10% penalty on top of income tax on any gains in the account.

If your child doesn’t use the full amount of the 529 plan for qualified higher education expenses distributions can be quite expensive from a tax standpoint. A Roth IRA can continue to grow for your retirement future if it’s not used for college expenses.

#3 Roth IRA’s may have the same tax-free treatment for college expenses. If you’re over age 59 1/2 at the time you take distributions from your ROTH IRA and you’ve had it for 5 years or longer, your distributions will be 100% tax and penalty free. It doesn’t even matter what you use the money for!

It’s not uncommon to see clients wait longer to marry and even longer to have children. This may be a viable strategy but you’ll have to do the math on when your child will enter college and see if you’ll be 59 1/2 or not.

Even if you’re not 59 1/2 your Roth contributions can be withdrawn tax and penalty free. Notice I mentioned contributions, not the growth! Let’s say you contribution $5,000 a year into your ROTH IRA for 5 years, you’ve now got $25,000 in Roth IRA contributions. This is referred to as your basis. If you’ve taken no other distributions and your Roth is worth MORE than the 25K in basis, you have access to 25K tax and penalty free from your Roth IRA.

#4 Roth IRA conversions also qualify. If you convert any of your IRA into Roth, those conversion amounts may also be distributed tax and penalty free even if you’re under age 59 1/2.  The conversion must have taken place at least 5 years prior to the distribution for college expenses.

Let’s say you have a 13 year old daughter and a $200,000 IRA. If you convert half of your IRA over 4 years (25K per year) you’ll have access to 25K per year for her first four years of college expenses. If you’re over 59 1/2 the growth can be withdrawn tax and penalty free as well!

#5 This may not even impact your child’s eligibility for student aid in future years. If you use your Roth IRA to pay for college expenses as they’re incurred, it generally will affect the amount of student aid your child will qualify for in future years. Even thought the Roth IRA isn’t reported on the FAFSA, the income from a Roth distribution would be reportable even if it’s a tax-free distribution. Depending on your financial situation however, it may not have a meaningful impact on your eligibility for future student aid. See #6 below.

#6 Fund college expenses with student loans! If you fund your child’s college expenses with student loans you can use Roth IRA distributions to pay off the loans. You’ll do this after college so the amount of student aid they qualify for won’t be affected while they’re in college.

In many cases the interest paid on student loans (up to $2,500) is also a tax deduction. The tax benefit adds a bit to this strategy. Another added benefit of your child taking out student loans is with timely repayment they’re actually building their own credit. Credit is a pretty important part of a great financial plan.

An even greater benefit is the leverage you have as a parent or grandparent. Your child or grandchild is on the hook for their student debt. That debt is your leverage! Use the potential to help pay off their student loan to make sure they work hard in college.

If they don’t deliver who’s to say you’ll sacrifice your tax-free retirement to pay off their student loans! Devious? Not if you explain it to your child up front. There’s a financial reward which comes with the student’s hard work and dedication.


Using a Roth IRA for college expenses in summary

It’s also better to slightly underfund your 529 plan accounts than to over fund them. If you overfund your 529 plan accounts you’ll end up distributing funds which aren’t for college expenses. This will force you to pay taxes and possibly penalties on the distributions.

There are no easy answers and college is expensive plain and simple. A Roth IRA investment may be a great part of your overall college savings plan strategy, especially in conjunction with student loans and 529 plan accounts.