Updated for 2021
Using Roth IRAs to Save for College - The Pros and Cons
Roth IRAs are a great, tax-efficient way for many families to save money for retirement, but can they also be useful in college education planning? Should you utilize a Roth IRA or a more traditional college savings account, such as a 529 plan, when saving money for your children’s college education? The answer is it really depends. If you’re absolutely certain that you want this money to be used to pay for your children’s education expenses, then it’s really hard to beat the tax-efficiencies of your state’s sponsored 529 plan. With that said, there are several unique characteristics of a Roth IRA that could make it an interesting option for some families. Below we will outline the pros and cons of using Roth IRAs to save for college.
Pros
1.) Flexibility
The primary reason to look at a Roth IRA as a funding vehicle for education planning is the flexibility that the Roth IRA provides. What if you save all this money for your children’s education and they decide that they don’t want to go to college and want to do something else instead? With a 529 plan, your only options are to either change the beneficiary to another family member and let them use the money for education instead, or withdraw the money from the plan entirely (incurring ordinary income taxes plus a 10% penalty on the earnings being withdrawn).
A Roth IRA, on the other hand, gives you options. Instead of using those savings to pay for your children’s education, you could just keep all of the money invested in your Roth account and use it for its primary intended purpose: growing your retirement nest egg. If, at some point, you hit a rough patch and need quick access to cash, the Roth IRA allows you to pull out all contributions that you have put into the plan without incurring any taxes or penalties on the money being withdrawn (see below for more details). If you are thinking about purchasing a home for the first-time (or have not owned a home in two years), you may use up to $10,000 of the earnings from these accounts to go towards a down payment. There are several ways that these accounts might be utilized, which gives you flexibility should your child decide that college is not the right move for them.
2.) Contributions can be withdrawn penalty-free at any time
Unlike most other tax-preferred accounts, contributions made to a Roth IRA account can be withdrawn without penalty at any time and for any reason. If you ever hit a rough patch (loss of job, disability, etc.), the liquidity that your Roth contributions provide could prove to be beneficial.
*Please note that this applies to Roth direct contributions only. Roth conversions must remain in the account for at least five years before being withdrawn to avoid penalty, while withdrawals from Roth investment earnings (aside from some exceptions) prior to age 59 ½ will incur ordinary income taxes and a 10% penalty.
3.) Roth Earnings Can Be Withdrawn Penalty-Free for College Expenses
While Roth contributions can be withdrawn tax and penalty free at any time, withdrawals of Roth investment earnings before age 59 ½ are generally subject to ordinary income tax, as well as a 10% penalty on the amount being withdrawn. If you use your Roth IRA to pay for qualified college expenses, however, you still have to pay income taxes on the earnings being withdrawn, but the IRS waives the 10% penalty.
While this isn’t quite as efficient of an option as the 529 plan (which provides tax-free distributions for qualified education expenses), the Roth still provides tax-deferred growth for college savings, along with significantly more flexibility for the owner of the account. Should your child end up not needing the money for college, you can keep the earnings inside the Roth and allow it to continue to compound until retirement, where you may make withdrawals income tax-free.
4.) Wider Range of Investment Options
Most 529 plans have fairly limited investment options that are offered inside their plans. This is not always a significant issue, as some state sponsored plans might provide fund selections that, while limited in scope, include an assortment of solid, low-cost funds to choose from. However, there are also many state-sponsored plans that have fund options with very high expense ratios that are not optimal for investment purposes.
With a Roth IRA, on the other hand, you have the ability to invest in practically any mutual fund or ETF of your choosing. Instead of choosing between a limited assortment of high-cost, poor performing funds, you can build a solid portfolio comprised of low-cost funds that could perform significantly better for you over the long haul.
5.) Roth Assets are not used in Financial Aid Calculations
One benefit of saving money in a Roth IRA for education expenses is that Roth assets are not factored into financial aid calculations. Savings in 529 plans, on the other hand, could reduce your financial aid package by as much as 5.64% of the account value of the plan. For example, if you had $10,000 in a 529 plan, your financial aid package could be reduced by $564.
Cons
1.) It Eats into Your Retirement Savings
The biggest downside from using a Roth IRA as an education funding vehicle is that you are allocating monies in one of the most beneficial retirement accounts around for your children’s education instead of your own retirement. The Roth IRA’s chief benefit, and the one that sets it apart from most other retirement accounts, is the ability to make tax-free withdrawals of both contributions and investment growth from the account during retirement. By earmarking the limited contributions that you are allowed to make annually into a Roth (see below) for your children’s education instead of your own retirement, not only are you sacrificing the tax-free withdrawals of assets that you have in the account currently, but you’re also sacrificing the compounded interest and investment growth that you could receive in future years that you also could withdraw tax-free in retirement.
2.) Income Limitations
The IRS places limitations on how much you can make in a given year and still make direct contributions to a Roth IRA for that year. In 2019, contributions to Roth IRAs for married couples that are filing jointly begin phasing out with MAGIs (Modified Adjusted Gross Income) of $198,000 ($125,000 for singles) and are completely phased out at MAGIs of $208,000 or higher ($140,000 for singles). Note that this is on a year-by-year basis, so if you are above the limits for this year but next year see your income fall back below the limits, you may contribute once again. For those with incomes above this threshold, utilizing a backdoor Roth IRA strategy might be an appropriate alternative solution to funding a Roth IRA.
3.) Contribution Limitations
Another downside of using a Roth for education funding is the fact that Roth IRAs have relatively low annual contribution limits. While the 529 plan does not have a hard and fast limit on how much you can contribute in a given year (sans gift tax consequences for contributions of $15,000 or more per person in a given year), Roth IRAs have annual limit of $6,000 per person for 2021. This contribution cap might prove too limiting for families who want/need to save more money for college than the $6,000 limit.
4.) No State Tax Deduction on Contributions
Many states provide state income tax deductions for contributions made to their sponsored 529 plans. Contributions to a Roth IRA do not receive this state tax deduction. This could be a significant deterrent for those who reside in states with high state income tax rates.
5.) Roth Earnings are Taxed as Income
As mentioned above, while the 10% penalty is waived for qualified education expenses, distributions of Roth investment earnings will be taxed as ordinary income. This could prove to be painful for families that find themselves in higher income tax brackets, and as explained below, could also affect financial aid eligibility in the latter parts of college. Remember, however, that the IRS allows you to take any or all of your contributions out at any point and for any reason of your choosing, so all of the money that you’ve contributed to the plan over the years must be withdrawn before you have to start paying any taxes on distributions. Because of this, you could be two or three years in to paying for college before this becomes an issue.
6.) Begins to Affect Financial Aid Eligibility in Later Years of College
While Roth assets, as previously mentioned, are not factored into financial aid calculations, all withdrawals from a Roth IRA will be counted as income on future financial aid applications, even withdrawals of Roth contributions. It’s true that you can make withdrawals of Roth contributions whenever you wish and for whatever purpose without incurring any income tax or penalty from the IRS, but these distributions will still count as income when it comes to applying for financial aid through FAFSA. Thus, the additional income generated through Roth withdrawals could reduce the amount of financial aid that your child qualifies for in the latter years of schooling.
Conclusion
If you are 100% sure that you want the money to be used for education expenses, then saving for college expenses via a 529 plan is probably the best way to go. With that said, if you don’t have enough retirement savings or are unsure if your child will actually want to go to college, then the flexibility that the Roth IRA provides could provide a good alternative. If you want to have a more detailed discussion on what is the best course of action for your specific situation, feel free to email me at daniel@sweetgrassfp.com or schedule a free introductory consultation.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Daniel Patterson, and all rights are reserved. Read the full disclaimer here.
