Last week we talked about the potential benefits of saving for college with a Roth IRA. Even though it’s supposed to be a retirement account, there are certain situations where putting your child’s college money into a Roth IRA can make a lot of sense.
But there are some downsides to that approach too, especially when compared to using a 529 plan, and today we’re going to talk about some of the biggest.
Here are some reasons why you should think twice before using a Roth IRA for your college savings.
Are you sacrificing retirement?
There’s a limit to the amount of money you can contribute to a Roth IRA. In 2014 and 2015 that limit is $5,500 per year. So any money you put into 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 pretty valuable for retirement. Assuming you keep the money in there until you reach age 59.5, all that money comes out 100% tax-free to use however you please. There’s no other account that lets you do that, unless your employer offers a Roth 401(k).
I’ve written before about why saving for college is actually a pretty low priority for me and my wife. One of the biggest reasons is that we think it’s much more important to save for retirement, and that’s simply because there are many ways to pay for college (loans, scholarships, work study, etc.) but there’s really only one way to fund our retirement. We simply have to save money or face the real possibility of not having enough money later in life.
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.
Flexibility can create confusion
One of the positives of saving for college with a Roth IRA is that if you don’t end up needing the money for college, you can just keep it in there and use it later for retirement.
But that flexibility can also create some confusion. 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.
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.
Can hurt financial aid eligibility
For the first year of college, a Roth IRA will likely be better for financial aid purposes than something like a 529 plan. That’s because none of your Roth IRA assets will be considered as part of your Expected Family Contribution on the FAFSA application.
But if you withdraw money from your Roth IRA to pay for college expenses (or anything else for that matter), the full amount of that withdrawal will be considered income on the next year’s FAFSA application and that will hurt your financial aid eligibility for that year.
And yes, that even includes the part of your withdrawal that isn’t taxed (you’re allowed to withdraw up to the amount you have contributed without paying taxes).
There are some ways you can plan around this that are beyond the scope of this article, but it’s definitely something to watch out for.
No state income tax deduction
One of the benefits of a 529 plan is that your state might allow a state income tax deduction for the amount of your contribution. Not all states offer 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.
Earnings you withdraw will be 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 will be taxed. So in this example, if you withdraw the full $30,000, you will have to pay taxes on $10,000 of it.*
This is in contrast to a 529 plan, where the money you withdraw is 100% tax-free as long as it’s used for college expenses. This is a big part of what often makes a 529 plan more attractive if you’re sure that the money will be used for college.
*There would normally be a 10% penalty on that $10,000 as well if you took the money out before age 59.5, but that penalty is forgiven if you use the money for college expenses.
Smaller contribution limits than a 529 plan
The most you can contribute to a Roth IRA in one year is $5,500 (for 2014 and 2015). If you include both parents it’s $11,000 per year. Those limits are the same no matter how many children you have, though there is a $1,000 additional allowance if you are over 50.
With a 529 plan, you can contribute up to $14,000 per child. If you include both parents, it’s actually $28,000 per year per child.
And if you want to get really crazy, the IRS will actually allow you to contribute up to 5x that amount to a 529 plan in a single year, with NO tax consequences. Which means that each parent can contribute up to $70,000 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 more for college than a Roth IRA.
There are income restrictions that limit who is allowed to make contributions to a Roth IRA.You can see the limits here, but for married couples filing jointly it’s around $181,000 where you will start to be phased out.
There are no income restrictions with a 529 plan. Anyone can contribute no matter how much they make.
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. We will likely stop doing this once they are old enough to make decisions about the money themselves, 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 our kids wouldn’t actually have any claim to the money at all.
If you want to use your child’s gift money for college savings, an account that is specifically dedicated to that purpose, like a 529 plan or Coverdell ESA, might be a better way to go.
Should you save for college with a Roth IRA?
There’s no right answer here. A Roth IRA can be a great way to save for college in certain situations, but there are some real drawbacks that need to be considered.
In the end it all comes down to your goals and what’s important to you.
For those of you who are already on track for retirement without a Roth IRA and aren’t sure you want to fully commit your money to college, putting your college savings into a Roth IRA can be a nice way to save ahead while still giving yourself some flexibility.
But if you’re not fully on track for retirement, a Roth IRA might be better used for that goal first. And if you’re 100% sure you want the money to be used for college, a dedicated college savings account like a 529 plan can offer better tax benefits.
What do you think? Do you think the positives of using a Roth IRA for college savings outweigh the negatives? Why or why not?