Not to sound like a broken record, but: Your children have access to loans to fund their education. You do not have access to loans to fund your retirement. This is why the general rule is to never use retirement funds for college expenses. However, there are exceptions to every rule, so let’s explore why an investor may consider using a Roth IRA to save for college expenses.
Roth IRAs allow you to save after-tax money for retirement. Assets grow tax free, and distributions after age 59 ½ are generally tax free. The key is that your contributions to a Roth IRA can be withdrawn at any time without tax or penalty. If you are able to save up to the contribution limit of $5,500 a year to a Roth IRA for 10 years, you could easily have $55,000 saved for education expenses.
If your modified adjusted gross income is more than $194,000 for married filing jointly, you cannot make a direct contribution to a Roth IRA, but you can take advantage of a Roth conversion by making a nondeductible contribution to a traditional IRA and then immediately converting it to a Roth IRA. You should not owe taxes since you took no tax deduction for the IRA contribution, and if you converted immediately, there would be no growth on the assets converted, assuming there are no other assets in your traditional IRA. If you already have a traditional IRA, you may take withdrawals penalty free for higher education costs, but income tax on your withdrawal will be treated differently when coming from contributions or earnings. If you choose to save in this manner, you should enlist the help of a financial adviser or tax consultant as the withdrawal rules can get complicated.
Roth IRAs consider your withdrawals to first come from direct contributions. If you used the backdoor into a Roth because of your high income, you will not have any direct contributions. Conversion money has a five-year waiting period before it can be withdrawn penalty free. Furthermore, each conversion has its own five-year time period. Earnings are considered the last to be withdrawn. If you are older than 59 ½ and it has been five years since the first contribution, earnings can be withdrawn tax free. If you are younger than 59 ½—the likely scenario for most parents—and you withdraw earnings from your Roth IRA for higher education expenses, you can avoid the 10% early withdrawal penalty, but you will owe taxes on the earnings.
So why would you consider a Roth IRA for college savings over a 529 Plan, which was designed specifically for higher education savings? Mainly because any money not used for education expenses can remain in your Roth IRA, growing tax free for your retirement. If you have only been saving to your 401(k), your retirement assets are tax deferred. A Roth IRA can provide tax free retirement income. Additionally, if you are only able to save up to $5,500 a year for your retirement and your child’s education, your assets may be able to grow faster if combined. Remember, contributions and conversions come out first, so growth can remain in the account for your retirement. You also can control the investment selection in a Roth IRA, while a 529 Plan’s investment options are directed by the investment manager for the plan.
Additionally, Roth IRA assets are not counted in the financial aid equation, unlike 529 Plan assets. However, any withdrawals from a Roth IRA are considered income that may affect financial aid eligibility in subsequent years.
Most investors face a difficult balance between saving for retirement and education simultaneously. If you have questions on whether using a Roth IRA for education savings would work for your situation, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
Disclosures: This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
