College Savings Plans 102: Using a Roth IRA as College Savings

After covering the 529 Plan and Coverdell ESA, it’s time to cover some less dedicated college savings plans. 529 Plans and Coverdell ESAs are great vehicles for saving for educational expenses.

If you withdraw money for anything other than qualified educational expenses, though, you have to pay taxes on the gains in the account and a 10% tax penalty. What if your child doesn’t go to college? If you worry that maybe your child’s destiny lies outside of the college experience, maybe you need to explore some alternate savings plans. Let’s consider using a Roth IRA as a college savings plan.

Roth IRA Basics

A Roth IRA is a retirement savings plan. You deposit after-tax money into the IRA and invest the funds as you choose. Any dividends, interest or capital gains coming into the account are not taxed. At retirement age, you withdraw the money without paying taxes. However, you can also withdraw the money without paying taxes for purchasing a first home or for qualified educational expenses.

You can also withdraw contributions from a Roth without penalty, as long as they have been invested for at least 5 years. That rule gives investors a lot of flexibility.

Want to know the difference between types of IRAs?

Restrictions on Using a Roth IRA as College Savings

If you want to use a Roth IRA as a college savings plan, you should know the basic rules.

First, rules limit contributions to Roth IRAs to $5500 per year ($6500 if you are over age 50). You must have earned income equal to the contributions. Rules also limit or even prohibit contributions for those with high incomes. The limits start at over $116,000 for singles or $183,000 for couples.

If you are using the qualified education expense rule to take money out of a Roth, you can only use a Roth IRA for qualified educational expenses at an eligible institution. The expenses must be for you, your spouse, your children or grandchildren.

Finally, if you withdraw account gains to pay for college in addition to contributed amounts, you’ll owe taxes on the income that has never been taxed.

Advantages of Using the Roth IRA as College Savings

The biggest disadvantage of the 529 plans and Coverdell plans comes into play if you can’t use them as intended. 

If your child doesn’t go to college, doesn’t go to an eligible institution, or receives a full scholarship, you have a couple of choices for a 529 or Coverdell plan. You can transfer the plan to another related beneficiary, or you can withdraw the money and pay extra taxes. That’s okay if you have to send another child  to college, but can be a real disadvantage if you don’t.

That’s the beauty of saving in a Roth. If you have been saving college money in a Roth IRA that you can’t use for college expenses, you have more retirement savings. You’ll have more money that you can withdraw, tax free, for any purpose, once you turn 59 1/2.

That leads to another advantage for older parents: If you are over 59 ½, you can withdraw money from a Roth IRA tax free, period. This means that you can use the money from a Roth IRA to fund non-qualified educational expenses as well, like an ineligible program or room and board. You aren’t confined to qualified expenses, like you are with dedicated college plans.

There are a couple of other factors to consider, though I’m not sure they are really advantages. When compared to a 529 plan, you have more investment choices, so your money may grow faster. When compared to a Coverdell, the $5500 per year is considerably more money to invest than the $2000 per year allowed in the Coverdell. In both cases, however, you may be better served by a combination of a 529 and a Coverdell. You can invest in a wide variety of options in a Coverdell, and the only limit on 529 contributions is the gift tax.

Disadvantages of Using a Roth IRA as College Savings

If you plan to use a Roth IRA as college savings, and have built up your retirement savings in 401Ks and other accounts, then you may be on track to retire. But if you haven’t saved enough for retirement, like almost half of Americans? Then you probably need to bulk up your retirement savings instead of raiding them for college tuition.

College and retirement are both expensive. The difference is that college is usually shorter, and there are a lot of financial assistance programs for college students. While you may not want to leave your child with a lot of debt, you also don’t want to need their assistance in retirement. If you have to make a choice, retirement savings trump college savings.

Another problem is that using a Roth IRA to save for college has a negative effect on student aid calculations. Many sources will tell you that the Roth IRA will not count as an asset on the FAFSA application, because a Roth IRA is considered a retirement asset. This is true. However, Roth distributions do count as income on FAFSA, even though they are not taxable. Distributions from a college savings plan do not.

Unfortunately, income counts more than assets in determining how much financial aid your student will receive. Additional income will usually reduce aid more than having a 529 plan. You may want to wait until your student’s final year to use a Roth for college expenses.

Final thoughts

There may be some advantages to using a Roth IRA as college savings in certain circumstances. If you have an older child who doesn’t seem oriented toward a traditional college experience, maybe you shouldn’t contribute more to a designated college savings plan. Once you have plenty of other retirement savings, then it may make sense to divert some earmarked college savings into a Roth IRA.

At worst, you’ll end up with a little extra money in retirement.

For most people, though, a 529 or Coverdell plan is a much better college savings vehicle. Use the Roth for your retirement.

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This article is for informational purposes only. Investors should do lots of research and ask many questions to determine the best college savings plan for their personal situation.

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