Why You Should Consider a Roth IRA for College Savings

Roth IRA for College Savings

Most parents I work with want to know the best way to start saving for their child’s college education. It’s just one of the first things that comes to mind as people start their families.

I’ve written before about the benefits of using a 529 plan for college savings, and if you’re sure that the money you’re saving will be used for college expenses, then that’s still the best way to go in most cases.

But if you’re not quite sure, using a Roth IRA for college savings instead of a 529 plan can give you some flexibility

But wait! Isn’t a Roth IRA a retirement account?

It is, but it has a few characteristics that also make it a reasonable place to put your college savings, especially if you want to keep the option of using the money for retirement instead of college.

There are pros and cons to using a Roth IRA for college savings, and in this post we’re going to look at the pros. You can click here to learn more about the cons.

So here are some of the reasons why you should consider using a Roth IRA for college savings.

The money is tax-deferred

You don’t get a deduction for money you contribute to a Roth IRA (like you would with a 401(k) or Traditional IRA), but the money within the account grows tax-free (click here for more on the difference between a Roth IRA and a Traditional IRA).

What that means is that your money can actually grow faster than if it’s held in a regular savings account or taxable investment account, because you aren’t losing money to taxes along the way.

Keep in mind that a 529 plan works the same way, so this isn’t an advantage over a 529 plan. But it’s still a nice benefit.

You can withdraw your contributions at any time

With a Roth IRA, you’re allowed to withdraw up to the amount you have contributed at any time without penalty and without taxes. So if you’ve contributed $1,000, you can withdraw up to $1,000 without any financial consequences.

With a $5,500 annual contribution (the maximum currently allowed for an IRA), you could potentially build up $99,000 in a Roth IRA over 18 years just from contributions. If both parents are contributing, it could be $198,000. And that money would be available to spend however you pleased, which of course means it could be used for college. (This is also the reason why you could consider keeping your emergency fund in a Roth IRA.)

Note: If you roll money over from a Traditional IRA to a Roth IRA, you have to wait 5 years before you can withdraw your contributions without penalty.

There is no penalty on earnings if used for college

Your Roth IRA balance above and beyond the amount you have contributed is called your “earnings”. These earnings come from any investment returns you’ve earned since you opened the Roth IRA, and this money is subject to a few more restrictions.

In most cases, any withdrawal of earnings (that is, any withdrawal above the amount you have contributed) before the age of 59.5 will be subject to both taxes and a 10% penalty. This creates a pretty strong incentive to keep the money in there until you’ve reached what the government considers to be “retirement age”.

But there are some exceptions and college is one of them. If the money is used for higher education expenses for you, your spouse, your child or your grandchild, there is no 10% penalty. You still have to pay taxes on those earnings (until you reach age 59.5), but avoiding that penalty saves you a lot of money.

This isn’t quite as good as a 529 plan, where your withdrawals are 100% tax-free and penalty-free when used for college, but it levels the playing field a little bit.

Long-term flexibility

Those first three points mean that you can use your Roth IRA for college without taking a huge financial hit from taxes or penalties. But even then a 529 plan still comes out ahead if you’re sure you want to use the money for college.

So why would you even consider using a Roth IRA instead? The biggest reason is flexibility.

I’ve written before about why my wife and I put college savings so far down on our list of financial priorities. Things like retirement, insurance and even travel are more important to us, for the simple reason that while there are many ways to pay for college, those other things only have one option and that’s to either spend or save the money now.

But what if you take that to heart and still want to save a little bit for college? Maybe you aren’t trying to fund the whole thing, but you would like to be putting away a small amount of money just to give your kids a little bit of a head start.

A Roth IRA can be a great way to do that for the simple reason that it gives you some flexibility. You can decide to use the money for college, or you can decide to pay for college another way and keep the money in the Roth IRA for your retirement.

A 529 plan doesn’t have as much flexibility. If the money is withdrawn for anything other than college expenses, you not only have to pay taxes on the earnings but you’re hit with a 10% penalty too. Of course, you could always use that 529 money for a different child’s college expenses, or even for yourself or a grandchild, but using it for retirement would mean taking a big financial hit.

So if you’re not fully on track with your retirement savings, but you feel guilty about not putting anything towards college, a Roth IRA can be a good way to save some money in a place where it could be used for either.

Note: Keep in mind that you can’t use the money for BOTH college AND retirement. It’s still either/or. The potential pitfall of feeling like you’re saving for two goals at once is one of the downsides we’ll talk about in next week’s post.

Help qualifying for financial aid

There’s both an upside and a downside to Roth IRAs when it comes to qualifying for financial aid. Today we’ll talk about the upside, and next we’ll get into the downside.

The upside is that any money inside of a Roth IRA isn’t counted for financial aid purposes, while 5.64% of the money within a 529 plan is counted. So all else being equal, having that money in a Roth IRA as opposed to a 529 will make it easier to qualify for financial aid.

More investment options than a 529 plan

There are some good 529 plans and some bad ones. But in all cases the investment options within a 529 plan are going to be pretty limited. That’s not a big problem when the investment options are good (like with the Utah and Nevada plans), but it’s still limiting.

A Roth IRA will open up many more investment options. Honestly, you can invest in just about anything within a Roth IRA (with a few exceptions), which means that you have more freedom to implement whatever investment plan feels right to you.

One of the biggest potential advantages here is finding lower-cost investments. Even the best 529 plans are going to be slightly more expensive than some of the choices you have within a Roth IRA, and since cost is one of the most important factors in getting better investment returns, this is something to pay attention to.

The bottom line

While a 529 plan will likely be a better option if you’re sure you want to use the money for college (especially if your state offers a tax deduction for your contributions), a Roth IRA can be a good place to save for college if you’re not sure.

The money is tax-deferred, there’s no penalty when it’s used for college expenses, and it keeps open the possibility of using the money for retirement instead.

It’s an especially good option for someone who isn’t fully on track for retirement, but still wants to put money aside for college. You can open a Roth IRA specifically for your “college savings” and leave yourself with the option to change your mind down the road.

There are some downsides to this strategy though, and you can read all about them here: The Downsides of Saving for College with a Roth IRA.

Would you ever use a Roth IRA for college savings? Why or why not?

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6 Comments... Read them below or add one of your own
  • Tracy October 30, 2014

    Are you going to discuss the Coverdell ESA in this series? I wish more people were aware of that option as well. Thanks!

    • Matt Becker October 30, 2014

      Great question Tracy! I won’t be talking about the Coverdell ESA much in these two posts but it’s definitely a topic I will be writing about in the future. Maybe in the near future thanks to your suggestion.

  • J. Money October 30, 2014

    Interesting comparison for sure… We’ve ended up going with 529s for both kids, mainly because of our state’s benefits, but I do wonder if it’s the right way to go or not. I guess the beauty is you can always stop with one and start contributing to another if plans/life change, eh? Wouldn’t be the worst problem to have… (that would be having $0.00 saved for college or whatever else the rascals end up needing it for!)

    • Matt Becker October 31, 2014

      We’ve used 529s for our kids too for two main reasons: 1) We want to keep our Roth IRAs for retirement, and 2) With the money “definitely” earmarked for college, a 529 has better tax advantages. And we’ve never even gotten the state income tax deduction, so you guys get even more benefit than we do. And you’re absolutely right that this isn’t an either/or. You can change your mind, or even do a little bit of both. So the main point here is really that a Roth IRA option for college savings, but it’s certainly not the only one.

  • Jacob October 31, 2014

    This is our current course of action. 529’s don’t do much as we don’t have state taxes, and we want the flexibility. I hate locking in money for something we have NO idea will happen 18 years from now. Not that our kids will skip college (they WILL definitely go somewhere), but the path may have many variables (scholarships, etc.)

    Also, for FAFSA purposes, remember that that the Roth balance won’t count against you unless you withdraw from it. Here’s the answer (quote from Kiplinger’s article)

    “‘The key’, says Deborah Fox, founder of Fox College Funding in San Diego, ‘is to not withdraw the money until you are no longer applying for financial aid.'”
    ( Read more at http://www.kiplinger.com/article/college/T042-C001-S001-how-roth-iras-affect-financial-aid-eligibility.html#tIz0Hid6Ww5JiXgY.99 )

    • Matt Becker October 31, 2014

      The flexibility is definitely nice, especially when, as you say, 18 years is so far off. I mean, you already have people starting to seriously question the value of a traditional college education, and really who knows where that will go over the next 2 decades or so?

      And you’re 100% right about the FAFSA implications. That will be part of next week’s post. But I think some people would be pretty frustrated, or even financially hurt, but not being able to actually use the money for the first 3 years. And what if you have more than one child and the second one is starting while the first one is finishing? Then you might have to wait until that 2nd child is finished if you want to avoid a negative impact on FAFSA. So shielding assets is a good thing, but since income is much more important I think that the negative impact of the withdrawals needs to be a serious consideration.

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