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.
Now, I have a lot of thoughts on this topic, including a number of reasons why saving for college shouldn’t be a top priority.
But if you’re really ready to start, and if you’re 100% sure that you want to save money specifically for education, contributing to a 529 plan is usually the smart decision. This is especially true now that you’re allowed to use up to $10,000 of your 529 money per year for K-12 private school tuition. The tax breaks offered by 529 plans are hard to beat when the money is used for education.
But if you’re not 100% sure that you want the money you’re saving to be exclusively for education, it might be smarter to use a Roth IRA for college savings instead of a 529 plan.
But wait! Isn’t a Roth IRA a retirement account?
Technically it is, but Roth IRAs are incredibly flexible and they have a few characteristics that make them specifically helpful for college savings, especially if you want to at least keep the option of using the money for retirement instead.
There are pros and cons to using a Roth IRA for college savings, and in this post we’re going to look at both sides.
The pros of using a Roth IRA for college savings
1. Tax-free growth
While the money you contribute to a Roth IRA isn’t deductible like it is with a 401(k) or Traditional IRA, it DOES grow tax-free. Which means that your money can grow faster than if it’s held in a regular savings account or taxable investment account, since you aren’t losing money to taxes along the way.
Keep in mind that 529 plans work the same way, so this isn’t an advantage over a 529 plan. But it’s a nice benefit over other types of savings accounts.
2. Availability of contributions
With a Roth IRA, you’re allowed to withdraw up to the amount you have contributed at any time and for any reason, without penalties or taxes. So if you’ve contributed $1,000 to your Roth IRA, you can withdraw up to $1,000 whenever you’d like and use it for whatever you’d like.
With the current $5,500 maximum annual IRA contribution ($6,500 if you’re 50+), 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 on whatever you’d like, including college tuition.
Note: If you convert pre-tax money from a Traditional IRA to a Roth IRA, you have to wait 5 years before you can withdraw that money without penalty.
3. Penalty-free for college
Your Roth IRA balance above and beyond the amount you’ve contributed is called your earnings. These earnings come from the 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 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 to this rule, and college is one of them.
There is no 10% penalty if the money you withdraw from your IRA is used for qualified higher education expenses for you, your spouse, your child, or your grandchild. You still have to pay taxes on the earnings (until you reach age 59.5), but avoiding that penalty can save 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 qualifying education expenses. But it levels the playing field a little bit and again makes a Roth IRA more attractive compared to other types of savings accounts.
4. 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 of a 529 plan? The biggest reason is flexibility.
I’ve written before about why my wife and I put college savings near the bottom of our list of financial priorities. Things like financial independence, 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 goals require either spending or saving the money now. There is no other option.
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’d 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 save money now, and later on you can either decide to use the money for college or to keep the money in the Roth IRA for your retirement and pay for college another way.
A 529 plan doesn’t have as much flexibility. If the money is withdrawn for anything other than qualifying education 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 or any other purpose would mean taking a significant financial hit.
So if you’re not fully on track with your retirement savings, but you feel guilty about not saving for college at all, a Roth IRA allows you to save and invest your money in a way that keeps it available for either goal.
5. Financial aid benefits
There’s both an upside and a downside to Roth IRAs when it comes to qualifying for financial aid. We’ll get into the downside below, but the upside is that any money inside of a Roth IRA is ignored for financial aid purposes, while 5.64% of money within a 529 plan is counted.
So all else being equal, having money in a Roth IRA as opposed to a 529 plan will make it easier to qualify for financial aid.
6. More investment options
There are some good 529 plans and some bad ones. But in all cases the investment options within a 529 plan are pretty limited. That’s not much of a problem when the investment options are good, like with the plans offered by New York and Utah. But it can be a significant problem with other plans.
One of the biggest advantages here is the ability to minimize your investment fees. 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 the single best predictor of future returns, this is something worth paying attention to.
The cons of using a Roth IRA for college savings
1. Sacrificing retirement
There’s a limit to the amount of money you can contribute to a Roth IRA. In 2018 that limit is $5,500 per year, unless you’re 50 or older in which case it’s $6,500. So any money you contribute to a Roth IRA that gets earmarked for college means you have less space available to save for your own retirement.
And that Roth IRA is valuable retirement space. Assuming you wait until age 59.5, you get to withdraw all of that money 100% tax-free and use it however you please. There’s no other account that lets you do that, unless your employer offers a Roth 401(k).
Additionally, while there are many ways to pay for a college education, there’s only one way to pay for your own retirement and that’s by saving money. Beyond Social Security or receiving an inheritance, there just aren’t any other options.
If you’re fully on track for retirement without using a Roth IRA, then using it for college won’t hurt your retirement savings. But if not, you run the risk of using up valuable retirement space for something that could be done elsewhere.
One of the biggest benefits of using a Roth IRA for college savings is that if you don’t end up needing the money for college, you can simply keep it in there and use it later for retirement.
But that flexibility can also create some confusion. Because you have to remember that while you can use that money for EITHER goal, you can’t actually use it for BOTH goals. It’s one or the other, and that needs to be factored into your long-term planning so that you’re not accidentally double-counting.
If you would like to use part of your Roth IRA for retirement and part for college, one way to remove the confusion is to open up two different Roth IRAs. That way it’s always clear which money is for which purpose.
3. Financial aid eligibility
Up above we talked about the fact that money within a Roth IRA is not counted as an available asset for financial aid purposes. This serves to decrease your Expected Family Contribution on the FAFSA application and increase your odds of receiving financial aid.
The downside is that if you withdraw money from your Roth IRA – whether to pay for college expenses or for any other purpose – the full amount of that withdrawal will be counted as income on future FAFSA applications. And given that income has a much bigger impact on financial aid than savings, this can be a big drawback.
And yes, this even includes Roth IRA withdrawals that aren’t counted as income for tax purposes. Because while you’re allowed to withdraw up to the amount you’ve contributed to a Roth IRA at any time and for any reason without paying taxes or penalties, you still have to report those withdrawals as income specifically for FAFSA purposes.
There are some ways you can plan around this that are beyond the scope of this post, but it’s definitely something to watch out for since it can have a big impact on your child’s financial aid eligibility.
4. No state income tax deduction
One of the benefits of a 529 plan is that you might be able to deduct some or all of your contributions for state income tax purposes. Not all states allow this, and some states don’t even have an income tax to begin with, but for those that do it can be a big benefit.
You won’t get any deduction for contributing to a Roth IRA.
5. Earnings are taxed
With a Roth IRA, you are always allowed to withdraw up to the amount you have contributed without any tax or penalty (with some exceptions). So if you have contributed $20,000 and your account balance is now $30,000, you can withdraw up to $20,000 without owing any taxes.
But any amount you withdraw over what you have contributed – your earnings – will be taxed. So in this example, if you withdraw the full $30,000, you will be taxed on the $10,000 of earnings.*
This is in contrast to a 529 plan where the money you withdraw is 100% tax-free as long as it’s used for qualifying education expenses. Which is simply to say that if you end up using the money for college, a 529 plan will likely come out ahead.
*There would normally be a 10% penalty on that $10,000 as well if you take the money out before age 59.5, but that penalty is forgiven if the money is used for qualifying higher education expenses.
6. Smaller contribution limits
The most you can currently contribute to a Roth IRA is $5,500 per year, or $6,500 if you’re 50+. If both you and your spouse or partner contributes, it adds up to a combined $11,000 per year max across all children ($13,000 if you’re both 50+).
There are technically no annual contribution limits for 529 plans, though in most cases the federal gift tax effectively sets the limit at $15,000 per year, per child. And if you include both parents, that increases to $30,000 per child.
And if you want to get really crazy, the IRS actually allows you to contribute up to five times that amount in a single year, with NO tax consequences. Which means that each parent can contribute up to $75,000 per year, per child. (Note that if you do this, any further contributions within the next 5 years may be subject to special taxes. This is an area where it can definitely pay to talk to a professional first.)
Simply put, a 529 plan allows you to save a lot more money for college than a Roth IRA does.
7. Income restrictions
There are income restrictions that can limit your ability to contribute to a Roth IRA, or even prevent contributions altogether. For married couples filing jointly in 2018, your ability to contribute is phased out from $189,000 – $199,000. For single and head of household filers it’s phased out from $120,000 – $135,000.
On the other hand, there are no income restrictions with a 529 plan. Anyone can contribute no matter how much they make.
8. Not great for gift money
One of the ways my wife and I have started saving for college without making big contributions ourselves is by putting the gift money our kids receive into their 529 plans. It’s not a lot, and we’ll likely stop doing it once they’re a little bit older, but for now it’s a nice way to start building those savings.
Family members are usually excited about this, since they like the idea of contributing to our boys’ future. But I don’t think they would be quite as excited if we were putting that money into a Roth IRA, where the money would technically be ours even if we said we were dedicating it to college.
A 529 plan is much better suited for this purpose.
Should you use a Roth IRA for college savings?
If you’re 100% sure that you want to save money specifically for education, then a 529 plan is likely to be the better option. The tax breaks are simply better when used for that specific purpose, which means that every dollar you save will have more of an impact.
But if you’re not 100% sure, or if you’re not already completely on track with your retirement savings, then a Roth IRA is a really good option. The tax breaks are still significant and the flexibility gives you the freedom to use the money for just about anything life throws your way.
There’s no definitive answer here, and it’s also worth mentioning that it’s not an either/or question. You are of course allowed to contribute to a variety of accounts in order to get some of the benefits of each type.
But at the end of the day, the Roth IRA is a useful tool that allows you to save for college while also keeping your options open.
So, what do you think? Which accounts are you using for college savings and why? Would you ever consider a Roth IRA for college savings?