The Pros and Cons of Using a 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.
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.
On the other hand, a Roth IRA allows you to invest in just about anything (with a few exceptions). Which means that you have more freedom to implement an investment plan you feel good about.
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.
Quick note: Do you want real answers to your personal questions about saving for college and other financial issues? Click here to learn how to get them.
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.
2. Confusion
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.
You may be able to get around these restrictions by executing either a Backdoor Roth IRA or a Mega Backdoor Roth IRA, but those options are not always available.
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?
I think we’re leaning toward the 529 ourselves. Seems like a better fit, and allows us to take the “both” approach when deciding between contributing to an IRA or 529.
The “both” approach is really ideal if you can swing it.
I think you’re right.
That said, for me, it’s still a tough question. I suppose if I knew beyond a shadow of a doubt that I would spend $xx,000 over four years at time certain and I’m absolutely tied to spending that amount, then it would be too easy. At another extreme, if I had no debt and enough disposable income to max out an IRA, 401(k), and HSA first, and still had plenty left over, then in this situation too, it’d be a no-brainer.
Given that kids can get scholarships, grants, or loans at a tax-deductible 3.4% — or just go to one of the dwindling number of schools inexpensive enough that they can be paid for by the child in between classes — I would probably err on the side of the flexibility of a Roth IRA — except for, as you mentioned, the kids’ gifts. Those would definitely head to a 529.
I think either one can be a great choice, and in many chases I think it’s a good idea to err on the side of putting more into the Roth IRA if only because saving for retirement should generally be a bigger priority than save for college.
The one thing I’ll say is that you mention you kids potentially getting scholarships or grants, and in those cases you would actually be able to withdraw those amounts from a 529 without the 10% penalty. The earnings would still be taxed, but avoiding the penalty would make it a lot less of a burden.
We’re contributing to both a 529 and a Roth. We prioritize the Roth but unfortunately still not maxing out. We were going to increase contributions to both…but will once again prioritize increase contributions to the Roth over the 529. Once we’re maxing out the Roth then we increase our 529 contributions.
We prioritized our Roths as well, but those are viewed as strictly for retirement. Since we were already maxing those out, going with a 529 for college savings was a pretty easy decision for us.
What are your thoughts on the ESA or Coverdale plan?
Great question! I actually have a post on the Coverdell ESA going live tomorrow, so check back in! Bottom line: I think it’s a great option. Here’s the URL for the post, but it won’t be up until tomorrow morning: http://momanddadmoney.com/coverdell-esa/.
Tons of detail here. Great post. There are some benefits for using a Roth for college savings but, as you point out, its not really meant for that and other plans like the 529 are more suitable.
Our son is only 2 so we’ve got quite a bit of time left ourselves. Before having a kid, I was dead set against parents paying for kid’s college. I paid for my own with loans and a scholarship and I think it helps with financial responsibility. Of course, now that we’ve got a kid my thinking is different. We have a Upromise Barclay card that feeds into his 529 account.
Amazing how kids can change your perspective, isn’t it? I would love to be able to pay for my two boys to go to school, but there are some reasons it’s not at the top of our list of priorities just yet. I like your approach to savings though. That’s definitely an easy way to get it started.
I think this is a great subject, and one that I’m delving into deeper since a little girl came into my life recently. How certain are you that withdrawals of contributions to a Roth will harm financial aid eligibility. I really hope that you are wrong about that point and it won’t be considered income. Contributions to Roth IRA’s are always made from taxes income to begin with. The money is counted as income from the year that it’s earned, then taxed, then you’re free to put it into the Roth account. It wouldn’t make sense for you to have to report it as income again. If you are talking about a Traditional IRA, then I think you are correct since those contributions were never taxes as income to begin with.
Nevermind. I reread your post and saw that I misunderstood what you were saying. Withdrawal of contributions aren’t considered income for tax purposes, but they will need to be declared on the FAFSA, thus affecting your child’s financial aid eligibility. Feel free to delete my remarks since I don’t want to add any unnecessary confusion to a good write-up.
No problem! I’m glad it got straightened out. And you’re exactly right here. Withdrawals of your Roth IRA contributions DO NOT count as income for tax purposes, but they DO count as income for FAFSA purposes. Our tax code can be incredibly confusing sometimes!
Quick add-on question. Within a normal college tuition (say $20K/yr for the sake of argument), would the second year increased FAFSA income calculation offset the calculation done by the FAFSA each year for owning a 529?
Thanks!
Hey Keith. Great question, and while I can’t give any definitive answer here, I will say that in general income counts much more against financial aid than than assets. Here’s a quick overview of what percentage of different types of assets/income count against financial aid: http://www.savingforcollege.com/financial_aid_basics/financial_aid_and_your_savings.php. Only 5.6% of assets inside a 529 plan count, while 22-47% of your Roth IRA withdrawals will count.
Hi Matt! I came across your site while trying to figure out how traditional & Roth IRA affect EFC in FAFSA application. Our total income is not enough to cover twin girls in college therefore financial aid is greatly needed. We were fortunate enough to save out of pocket $11,000 for 2014 and placed it in a traditional IRA. The good: our adjusted gross income for tax year 2014 is lower and got a bigger tax refund. The bad: the $11,000 contribution is added to the adjusted gross income thus increasing the EFC (estimated family contribution) & decreasing financial aid. Could Roth IRA have been the better option? I have also read that converting Traditional IRA to Roth will cause a higher increase in EFC. I really need to start saving for retirement since I lost all of it 2 years ago but it looks like saving for retirement and needing financial aid for college does not mix. Any advice?
Great question Carolyn! This stuff gets confusing quick, and I’ll be honest that I have to refresh myself on all the rules as well. So here is my understanding.
Contributing to a Traditional IRA or any other retirement account doesn’t hurt your financial aid eligibility. It just doesn’t help it either. That is, even though 401(k) and Traditional IRA contributions reduce your income for tax purposes, they do not reduce your income for FAFSA purposes. So while your Traditional IRA contributions didn’t help you qualify for financial aid, they didn’t penalize you either. Your FAFSA income was exactly the same as it would have been if you hadn’t made the contribution.
Contributing to a Roth IRA would not have changed this. Roth IRA contributions don’t reduce your income for tax purposes either, so again there would have been no difference.
The good news is that any money you contribute to a retirement plan now will NOT be included in the FAFSA calculation next year. That is, the $11,000 that’s now in your Traditional IRA, plus any other money that is already there, will be excluded from the FAFSA calculation next year. So while it doesn’t help you this year, it will help you in future years. A Roth IRA and 401(k) work the same way.
The bottom line is this: while saving for retirement doesn’t help you qualify for more financial aid in the year you save, it doesn’t hurt you either. So there’s no reason not to do it. And it will end up helping you in future years. So if you need to save for retirement, then by all means go ahead and do so.
Hope that helps! If you have any more questions please feel free to email me any time at matt@momanddadmoney.com.
Hi Matt,
Is it better to create a Roth IRA in my name or Roth IRA in a custodial account? Does it matter when needing financial for my two girls (age 13 and 15) for college?
Also can we use a 529 for oversea schools, which hopefully we can afford vs. the USA rising costs?
As of now I have $90K in IRA’s at age 54 and my wife has nothing at age 45?
Robert
Great questions Robert! On the Roth IRA, there’s never a one-size-fits-all answer but I would say that in most cases it would be best to have it in your name. The main reason is simply that it gives you the flexibility to use the money for retirement, which is key. Unless you’er fully on track for retirement savings with other sources, that’s probably the only reason that matters.
For financial aid purposes, I’ll be honest that I’m not 100% sure on the rules off the top of my head, but I don’t think it would be counted as an asset either way BUT I would assumed that withdrawals from a custodial account would count as the child’s income rather than yours, which would then be included at a higher percentage for next year’s FAFSA. Again, that would argue in favor of having it in your name.
Also keep in mind that you can only contribute to a custodial Roth IRA up to the amount of earned income your child actually has.
Finally, you can use 529 funds for some overseas schools, but not all. Here’s a search tool that you can use to look up specific schools: http://www.savingforcollege.com/eligible_institutions/.
Hope that helps! Let me know if you have any more questions.
I read recently in a book about saving for college that when colleges are deciding whether to provide aid in the form of grants (not loans) that one of the things they consider is whether the applicant’s parents have saved money for college. The colleges like to see that the parents have tried to save money for college. Theoretically, if the parents have saved money for college in a Roth IRA, that does not show up as college savings, in contrast to a 529 plan. Thus, it appears that someone who saves for college in a Roth IRA has actually not saved for college, and this, theoretically, could work against the student in terms of receiving grants. What are your thoughts and experience on this issue?
Great question Tim, and I’ll be honest that I don’t have a specific answer for you. I haven’t heard this myself, but that doesn’t mean it isn’t true. I do believe that most need-based grants are based on FAFSA, so I believe the calculations would be the same there. But other types of grants may have different criteria and honestly it may differ by school.
In general, I would approach things like this:
1. Save for your own retirement first and foremost.
2. Save for college in tax advantaged accounts, whether it’s a Roth IRA like I discuss here or a dedicated account like a 529 plan.
3. Be aware of how financial aid works, but don’t make too many decisions based on it unless you’re only a year or so away. Most aid comes in the form of loans anyways, so saving somewhere is almost always a better option.
Hello. I’m confused about you mentioning that a Roth IRA CANNOT be used for both education AND retirement. Does this mean if I contribute money to a ROTH and I make a withdrawal to pay for some educational expenses, the balance cannot be used for retirement? Thanks!
Hi Dayna. Sorry for the confusion! What I mean by that is that you can’t use the same dollar for two purposes. But you can absolutely use some of the Roth money for college and some for retirement. I just wanted to caution people about double-counting the money in there, thinking that all of it is available for both goals.
By the way…My husband and I are all set for retirement (or so we have been told by financial planners), so a ROTH IRA would be considered an “extra” for us. Our daughter starts college this fall and we did not realize or consider how expensive this would be. We have an eleven year old as well and want to make sure we are more prepared to help him get through at least the first year or two. I am still paying my own student loans and I don’t want my children to end up in tons of debt over their education. Any advice?
If know that you want to use the money for college expenses, a 529 plan or Coverdell ESA provides better tax benefits that a Roth IRA does. So I would at least consider that option if your retirement is already set without the Roth.
I also want to emphasize the point that any Roth IRA withdrawals will count as income for FAFSA purposes (even if not for tax purposes) and would therefore hurt financial aid eligibility the next year.
With that said, there are some advantages to using a Roth IRA, especially if you want to keep the flexibility of using the money for retirement if you don’t end up needing it for college.
Finally, whether it’s saving for retirement, paying off your own student loans, or whatever, in general I think it’s a good idea to take care of yourself before saving for your child’s college education. There are many options when it comes to paying for college but really only one when it comes to caring for yourself.
Hope that helps! Let me know if there’s anything else I can help with, and good luck!
Thanks for the clarification. Yes, we are trying to focus on repaying my student loans before trying to save for college for my 11 year old. I was trying to think of a way perhaps we could just have a small ROTH as a backup “savings” plan for current college costs or maybe my daughter’s last year of college (so we won’t worry about FAFSA. As it is, she doesn’t really qualify for anything so I’m not too concerned about that. Next question…Can I use money in a ROTH to pay off my student loans? Or is there a more creative way of saving money to do this (or just apply it monthly)? Thanks!
Gotcha. For student loans it’s probably going to be best to just pay them off as the money is available rather than saving ahead. The sooner you make a payment, the more interest you’ll avoid.
Can I fund a Roth IRA and if my child decides to go to college then I roll some portion of the IRA into a 529 at that time? Then I use the 529 to pay for the college and therefore don’t jeopardize my potential financial aid?
Just to be more specific, I mean to withdraw my contribution amount from the Roth IRA. I believe I have the right to that, tax and penalty free. So then I take that money and create a 529 plan once it’s clear that my kid is going for higher education. I then keep the Roth IRA earnings as extra retirement money.
I guess the drawback would be if I need to dip into the earnings of the IRA for higher education (say the contributions I made were not enough) then I will need to pay taxes on that. The 529 plan earnings do not get taxed when used for higher education.
Good question Brian. Actually, the big drawback to that strategy is that your Roth IRA withdrawal would count as income, which counts much more harshly against financial aid than savings/investments do. That’s true even you’re only withdrawing your contribution, in which case it WOULD be counted as income for financial aid purposes even though it’s NOT counted as income for tax purposes.
Hi Matt, thanks. Yes I gathered that through this article. The plan was for the IRA withdraw to happen years before the kid went to college. It’s just that at this young age there’s no telling what path he will take. So I open an IRA and say around 13 it’s clear he wants to attend college. At that time I withdraw my IRA contributions and open a 529 plan with. So the withdraw with have no impact on financial aid since it’s well before the college years. I would want to create the 529 as soon as it’s clear so it has time to grow tax free. Obviously it wouldn’t grow as much as if I created it from the start, but there’s always that risk that college just isn’t for the kid. It was just a thought…
Gotcha. Then yes, other than the points in the article and the one you mentioned about there not being as much time for tax-free growth, this seems like it would work. I haven’t actually encountered this strategy before so I can’t say for sure that there aren’t any additional pitfalls, but there are none that I can think of. Good luck!
I thought you could withdraw earnings from a Roth IRA if the account has been open 5 years or more. Another question, what if you have a 401k that you use for your retirement, would it be a good plan to open a Roth IRA for education funds if you are not sure if your kid will go to college, and you did it before the age of 13 to cover the 5 year earnings rule?
The rule you’re talking about Jerry concerns the ability to take “qualified withdrawals” in retirement. Basically, you have to wait 5 years from the date of your initial contribution before you’re allowed to withdraw the earnings tax-free, but even then you have to be age 59.5 or else there are taxes and penalties on the earnings (with some exceptions).
As for your other question, there are a number of pros and cons to that strategy, which are laid out both in the article above and this one. It can be a good way to maintain some flexibility, but you need to be careful to avoid the potential pitfalls.
Hi Matt,
Would it make sense to open the Roth IRA in the child’s name? This way my own IRA contribution limits wouldn’t be tied up and the child has her account for retirement.
Yes, that’s certainly an option but there are a few things to consider. First, when it’s in your child’s name it’s your child’s money to use. So you won’t necessarily be able to decide to use it for college yourself, as opposed to money that’s in your Roth IRA that you have full control over. Second, withdrawals would count as your child’s income, which would be an even bigger hit against financial aid. Third, your child must have earned income in order to contribute. You could still contribute to it from your own money, but you would only be allowed to contribute up to the amount of your child’s earned income.
So it’s definitely an option, and can be an effective one, but there are limitations that are worth considering.
I’m a college professor and my children (ages 6 & 9) “may” have access to a tuition-exchange program at either my institution or an institution that is part of our consortium. I say may because the process is pretty competitive and I figure I should be realistic about future changes to this program. I’m also divorced. He contributes about $2,000 a year to each of the kids’ 529 accounts; however, I’m not confident that this will continue. I have chosen not to contribute to the 529 plans and, instead, contribute the maximum to a Roth IRA each year (I have about $123,000 in these accounts already). Because of the tuition-exchange possibility, I worry about limiting the use of these funds long term. To your point, I try to be careful about my thinking with these funds – EITHER not BOTH and, you’re right, this is difficult. I am also maxing out my 503-b (and get a 9% match from my employer) – so I’m not ignoring my own retirement. Based on my specific situation, I feel fairly confident that I’m doing the right thing in focusing my college savings as Roth money, instead of 529. If you see a pitfall I’m missing I’d love to hear your thoughts!
Thanks for sharing your situation Susan! It sounds to me like your logic here is sound. The way you’re doing it, all of your money would be available to you for retirement if your children do qualify for this program, which is I’m guessing what you would want to happen. And at least for now, your children are also building money in college-specific accounts, so they’re really getting the best of both worlds.
Is there any benefit at all to saving via a Traditional IRA instead of a Roth IRA if both are available to me if it were to definitely be for child’s college?
In most cases I don’t think so, simply because your income is likely to be higher when your child is college age than it is now, meaning that withdrawals from a Traditional IRA at that point will likely be taxed at a higher rate. Or at best the same rate. So unless you have a good reason to believe that your income will be significantly lower at that point, I think a Roth IRA is preferable.
I am 48 and recently divorced. While married, my ex and I, were able to max out our 401Ks and contribute approximately $300,000 to a 529 account for our two children, ages 14 and 9. Since the divorce I am contributing 4 percent to my 401K. My company recently began offering a ROTH 401k and I am wondering if I wanted to contribute another $200-$300 a month to my children’s education, I am better off using that Roth 401K or a new 529 account. (I live in New Jersey which does not offer a tax deduction for 529 contributions and I believe I earn too much to contribute to a ROTH IRA.)
Unfortunately, Roth 401(k)s are not as flexible as Roth IRAs, and therefore not as useful for college savings in particular. You can read more about the withdrawal rules here, but the biggest points are that:
1) You must have had the Roth 401(k) for 5 years before being able to withdraw money without penalty.
2) Each withdrawal is a pro-rata share of contributions and earnings, unlike a Roth IRA where withdrawals are counted as coming 100% from contributions first.
You still may be better off putting money into a 401(k) than a 529 (more on that here), but a Roth 401(k) is generally not a great place to put money you want to use for college.
I don’t understand why you say a Roth can be used for retirement or college, but not both. Can you explain that?
What I meant to say is that each individual dollar can only be used for one or the other. Sometimes having a Roth IRA earmarked for both goals makes it feel like each dollar is available for both goals, which can make it feel like you’re more on track than you really are. I’m just trying to caution people against double-counting their money.
To your point, it is absolutely possible to use some Roth IRA money for retirement and other Roth IRA money for college.
Did you ever dive deeper into the ways around avoiding Roth Withdrawals from counting toward Income on FAFSA? I always figured the Roth was a great idea (assuming you don’t need that vehicle to hit retirement goals), because it is not counted on your initial FAFSA paperwork as income/assets.
At the point, couldn’t you just take a loan and not have to pay interest on it until 6 months after graduation? Meaning, no need to withdraw “income” from Roth until after your child has graduated, then pay off full amount with withdrawal of Roth Contributions? Since the child is already graduated, there would be no need to report on any additional FAFSA forms..
Maybe I am mixed up on how the payback occurs.
Good question Shawn. You may be able to use this strategy with subsidized student loans, but those are generally pretty limited in terms of the amount you can get. Most loans are unsubsidized, meaning that the interest accrues while you’re in school, even though you don’t have to pay it until you’re done with school, which would make this strategy a lot less attractive. Here’s a guide that explains more about the difference: Subsidized and Unsubsidized Loans.
The best strategy I know of is simply to wait until the income would no longer matter because the FAFSA lookback period has passed. If you child isn’t going to graduate school, that would generally mean waiting until his or her Junior year, since the FAFSA looks back two years.
I have two Roth IRAs and I’m planning on using some of the money from one or both of these accounts for my son’s educational expenses in his junior or senior year. (He starts college Fall 2017. I’m 56 years old and I won’t be 59.5 years old until his senior year.) Of course, I’d like to withdraw penalty free. One of your posts explained that a person must have had the Roth 401(k) for 5 years before being able to withdraw money without penalty. One of my Roth accounts (the one with less money in it) is over five years old and the other account (with less money in it) is not yet five years old.
Can I withdraw penalty free from either account if only one of them is five years old? If not, can I move money from the “younger” account into the “older” account without penalty?
Thanks!
Good questions Shelley. The answer depends on the specifics of your situation, so I can’t say for sure. But here is a really good and detailed breakdown of the various rules and contingencies: Understanding The Two 5-Year Rules For Roth IRA Contributions And Conversions.
If you’re just talking about Roth IRAs you’ve contributed to directly – and not money that either is currently in a Roth 401(k), has ever been in a Roth 401(k), or was converted from a Traditional IRA – then as long as one of your Roth IRAs has satisfied the 5 year rule, then all of them have satisfied the 5 year rule. It gets more complicated if you’re talking about money that was converted though, or if you’re adding Roth 401(k)s to the mix, and the article I linked to above gets into some of that.
As older-ish parents, we hope to keep contributing to our Roth IRAs. But, entering an expected 6-years of college expenses (2 kids) is just so hard to plan for! However, it seems that if we end up needing to take a distribution to help pay for college (or whatever) that amount will be counted as Income twice, possibly in the same year. Can that be correct?
Well, FAFSA now looks back 2 years and if you’ve taken money out of your Roth IRA in that time period, it will be counted as income. It should only be counted once, though it may be counted for both children if that’s what you mean, assuming they’re filling out the FAFSA in the same year.
I would definitely recommend speaking to a CPA or other financial professional who is familiar with these rules and can help guide you through your specific situation. It can be a little complicated to work through, especially when there are multiple children to consider.
Lori has the same question as me.
After-tax income that’s earned gets counted as income in the FAFSA year.
When that “after-tax contribution” is later withdrawn from a Roth IRA for education, it’s counted as income again on the FAFSA even if it’s not taxable income.
Seems like those same earned retirement dollars are being DOUBLE COUNTED as income. Why is that?
To be completely honest Michelle, I’m not sure what happens if you make both the contribution and the withdrawal in the same year. But as long as they occur in separate years, I do not believe that they will be double counted since the FAFSA only looks at one year’s worth of data.
So, I’m not seeing my idea in your article or in the comments. But I could have easily missed it.
I am leaning towards a Roth IRA because of a couple of things –
1) What if my child doesn’t end of going to school (bad idea)
2) What if my child gets scholarships, i’d rather not be penalized because of that
3) I will be 54 by time my child goes to college, so the idea is they will take loans out, build their credit and then when i turn 60, pay off they loans with the IRA or as much as i can at that point.
Just my two cents. Would love any feedback on my thoughts.
Thanks!
All good thoughts Ben. In terms of scholarships, you are allowed to withdraw up to the amount of the scholarship from a 529 plan penalty-free, though the earnings will still be taxed. It’s not quite as advantageous as a Roth IRA in that situation, but it makes it a closer comparison.
As for paying off your loans with your Roth IRA, there’s nothing I know of that would prevent you from doing that as long as you’re older than 59.5. You would just need to be careful about coordinating with FAFSA applications if you have younger children still in school.
My oldest daughter is now married and will be attending a graduate program for Physician Assistant this year and next year. Her FASFA was just on income from her and her husband last year. However, I still have money in a ROTH that she did not use in her undergraduate due to scholarships, etc. If I pull the money will it affect her FASFA eligibility next year given she is married and qualifying on just her income?
This is a really good question Julie and I actually asked a friend of mine, Nannette Kamien, for help because I didn’t know the answer. Nannette is also a CERTIFIED FINANCIAL PLANNERTM and specializes in college planning, so she knows her stuff.
So, two things here.
First, just know that FAFSA actually looks back two years now, so anything you do this year will not affect anyone until two years from now.
Second, here is Nannette’s response to your specific question:
“Well my first thought is that she should keep the ROTH for herself, seeing as it’s a retirement account and all, and not spend it on the daughter.”
“That being said, the only way I can see that it would affect the FAFSA is if she gives the money to the daughter and it’s sitting in the daughter’s bank account when she fills it out. Much better to fill out FAFSA and then get the money since assets are valued as of the day you fill it out. However, the gift of that money could still have implications. May be better to just have the mom pay the school directly. I wouldn’t imagine there is much financial aid to be had for graduate PA programs that would be cut if her mom paid.”
I hope that helps!
Regarding the Julie Gould comment on March 16, 2018…
So if I were to withdraw $$$ out of my Roth IRA, and pay it directly to the college, would my child still have to claim that amount paid on the FAFSA form although it was not income given to the child?
Here’s the response from Nannette:
“If the student is independent they don’t report parent information at all. So the question boils down to whether the fees paid for tuition would show up as student income or cash support. I don’t think it’s income but could be considered to be cash support that needs to be reported. Now that may or may not affect aid. If the student isn’t receiving need based aid, it shouldn’t matter.”
In other words, I don’t have a definitive answer for you. For this kind of complex situation, it would probably be worth speaking to an accountant with specific expertise in financial aid planning.
My daughter purchased Roth IRA’s for her child, but put no other name on the IRA. Unfortunately that daughter passed away. Her daughter is now 18 and will be starting college this fall. Will that daughter be able to access those funds?
I’m sorry to hear about this situation Angie. I wish I could help but it really depends on a lot of variables that I don’t know. If there was no beneficiary named on the account, then it should have been settled in probate who the money went to. I might start by calling the company that held/holds the Roth IRA and ask them who is able to access the money.
Hi Matt, I’ve 2 boys in which older one just turned 5 and the younger one is 21 months. Recently I was talking to my colleague regarding ROTH IRA and 529 plan to save money for their college education. Which one do you recommend based on situation.
It really depends on your personal goals and your overall financial situation. In addition to this article, here’s another one that can help you weigh the pros and cons: How to Choose the Best College Savings Account (and When You Shouldn’t Use One).
And if you’d like more personal guidance, you can always sign up for a Jump Start Session so that we can talk through it together and I can make a definite recommendation. You can learn more about what that session is and how to sign up here: momanddadmoney.com/jump-start.
My husband and I attended a college financial workshop last week and were told that IRAs *are* now counted as part of assets on the FAFSA/CSS. The presenter said that since you can now access those funds to use for education, they are counted and utilized as part of the computation to determine our EFC. He made it seem like perhaps this is a recent change. Any thoughts on that?
This workshop also suggested that there are ways to “protect” that money, vaguely suggesting shifting it to other types of accounts that would not be visible, but of course we have to pay for their consultation program to find out specifically how it would work for our individual situation. It seems like to make major financial changes now for our FAFSA/CSS for our daughter (high school senior) would incur penalties and such, although it is an attractive possibility because I don’t know how in the heck we are going to pay what our EFC is likely to be. I’m just trying to get a handle on this, and I am looking for somewhere that really explains a good breakdown of how the EFC is determined on both of these forms, and what we might be able to do to lower it. Any suggested resources?
First, I would likely stay far away from whoever is putting on this workshop. Based on your description (the part about protecting the money and shifting it to other types of accounts), I can almost guarantee you that they are trying to pitch you on some kind of whole life insurance, which is much more likely to hurt you than help you. This is unfortunately a common scare tactic that is used to sell you an expensive product that pays them a big commission.
Second, IRA and other retirement assets are not counted in either the FAFSA or the CSS. Distributions from those accounts would count, depending on the timing, but the assets themselves do not unless they are owned by the child. Anyone telling you otherwise is either mistaken or lying.
Third, when it comes down to it, income is a much bigger factor in financial aid calculations than your investments and other assets are. Even if it ends up slightly hurting your financial aid eligibility, it is almost always better to have more savings than less. And in any case, most financial aid comes in the form of loans, which is a far cry from free money.
Finally, there’s good information on the EFC here, here, and here.
Hello! What a fabulous and informative post! I appreciate you are still answering questions on it 4 years later!!
I am trying to decide if it makes sense financially to open a Roth IRA for the purposes of college savings. My children are 5 and 4. My husband and I are already saving enough to meet our baseline retirement goals, and although our income is usually right around the Roth IRA income limit and some years goes over (due to husband’s commission structure), that is without factoring in our 401k contributions. I believe we have enough wiggle room with 401k contributions to keep us under the income cap most if not all years.
So, since the kids started going to public school, we now feel comfortable investing an additional $12,000 annually, and we want to start saving for college. But I am hesitant to start a 529. (What if they get scholarships, what if taking a low-interest college loan is a better idea, what if one or both of them doesn’t want to go, what if free college for all becomes a reality, etc.) So Roth IRA sounds like a good plan to me. But my question is this: if husband and I both contribute max Roth IRA per year (think next year will be $12,000), but then in approximately 12 years we begin to withdraw our “contribution” amount to pay for college — and let’s say for argument sake we wind up withdrawing the entire contribution amount over the course of five years — is the “earnings only” that’s left at that point going to still make this the smartest way to invest this extra $12k annually? (If this factors in, we will likely still be working and could be contributing to Roth IRA for a decade or two after the kids’ college years are over, so eventually earnings plus principal would be back in play.)
Secondary question. Is a Roth IRA matured over 12 years “safe” enough for college savings? I understand that Roth IRAs are smartest when you are taking greater risks because you don’t pay taxes on the returns no matter how big they are…. But, I would hate to not at least have my principal to withdraw for the kids’ college tuition. Have you ever seen that happen? And, since that is the case, would you recommend that we use a managed account from Ally (or similar) versus managing it ourselves, or does the fee situation make it smarter to go it ourselves given the timeframe? We’re not professional money managers, but we are good at doing research and being diligent.
Sorry for the long question. I really just want to know if there is a downside to this that I’m not seeing. THANK YOU!!!!!
These are good questions Eden and the truth is that it’s impossible for me to say what the right approach is without really diving into all the details of your situation. But I will say that the Roth IRA gives you a lot of flexibility, which often makes it a really good place to start. Then, if you’ve maxed out your Roth IRAs and still want to save more, a 529 plan could be a good place for some of that extra savings. But it all really depends, and the following article gets into a lot of detail about the various pros and cons: How to Choose the Best College Savings Account (and When You Shouldn’t Use One).
As for your question about risk, a Roth IRA is like any other investment account in that it can be invested with a lot of risk (e.g. 100% stocks) or with pretty much no risk at all (e.g. a money market fund). I personally like to invest with Vanguard, and it’s pretty straightforward to choose an asset allocation that matches your appetite for risk and then to find a simple mix of funds that matches that asset allocation.
And of course, if you ever have more questions, please feel free to reach out any time. I am always happy to help!
Hi Matt,
Thanks for the article.
We’ve spread college money for our child between a 529 (21%), coverdale (29%), 2 Roth IRA’s (21%), and a plain ol savings account (29%).
We opened the IRA’s for the FAFSA savings, but I see from your article that’s only good until you use the IRA monies and can impact you the following year. I thought a read somewhere that Roth IRA money could only be used for the education portion and not room and board of college.
Do you know if that is accurate?
I like the Roth because if it’s not needed for college due to scholarships, grants, and such I can use it for retirement. I have a 401K as primary retirement money, so the Roths are just supplemental.
The 18K in plain ol’ savings should go into one of the other 3 I believe due to the measly .5% interest it gets now. Due to our age my wife and I can put 6.5k into each Roth IRA.
Would you have some thoughts on where to put the 18K? Maybe spread it among all the others?
Thanks
Jerry
Thanks for reaching out Jerry and I’m sorry for such a delayed response. My understanding is that IRA funds can be withdrawn penalty-free for room and board as long as the expenses are for an eligible family member who is enrolled at least half-time in a degree program (source).
As for the $18k in savings, I would first make sure that you have a dedicated emergency fund, as well as money set aside for irregular expenses. If those are covered through other means, and if that money is strictly meant to be used for college expenses, where to put it really depends on your personal goals, timeline, and the rest of your situation. This guide should help you decide: How to Choose the Best College Savings Account (and When You Shouldn’t Use One).
I think it is wise to save in both a 529 plan and a Roth IRA. I like the 529 plan because of the state deductions and the larger contribution allotments but I do not like them because 5.64% of a 529 goes against financial aid. The Roth is a great tool to use to pay off school loans your students senior year because at that point the withdrawal does not affect the students financial aid.
Hi Matt,
Forgive me if I am repeating a question, but above you state:
“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.*
I didn’t think that Roth earrings were taxable as long as it was a qualified deduction, like college. Is that not true? Does age have anything to do with this?
Thanks,
Kevin
If you are younger than age 59.5, the earnings are taxed but not subject to the 10% penalty as long as the money is used for qualified higher education expenses. If you are age 59.5 or older, you can withdraw any amounts for any reason without tax or penalty.
Thank you Matt. I guess that is one of the few benefits of being older parents….but it sure is hard to keep up with the kids!
Quick though on a play between 529 state deduction and roth ira. If your child is in college, it seems like you could withdraw Roth IRA funds, deposit those into a 529 for the state deduction, and then withdraw them again to use toward school yes? Of course there are the annual limits to the deduction, but this seems like a good way to let it grow in the roth, eliminate the risk of the child not going to school and still get a deduction.