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By Jeffrey Levine, IRA Technical Expert
For some time now, the cost of a college degree has been rising at perilously high rates, and as a result, the dream of one day going to college, for many, remains just that ... a dream. With college tuition and associated costs rising so dramatically, it’s no surprise that people are looking for new and creative ways to save for these expenses. One such alternative method involves the use of a Roth IRA over more traditional college savings vehicles, such as 529 plans and Coverdell education savings account. That may sound bizarre. After all, why would anyone use a retirement account to save for education expenses when there are accounts specifically designed to help plan for those costs? Nevertheless, here are three reasons why it may not be as crazy as you think.
#1 – Roth IRAs Aren’t Included as an Asset on the FAFSA form
When a child goes to college, if they want to receive student aid, the filing of a Free Application for Federal Student Aid (FAFSA) is pretty much a must. There are well over 100 questions on the FAFSA form, many of which are financial in nature and designed to help calculate what’s known as the expected family contribution (EFC). The EFC is essentially the amount that Uncle Sam thinks a person should pay for their own education and is calculated in part, based on the assets of a student and their parents.
When reporting assets on the FAFSA form, most assets, including 529 plans, are included in the calculation. That means by doing the “right” thing and diligently saving for a child’s education in a 529 plan – a plan expressly designed for that purpose – could end up increasing their EFC, reducing or eliminating the amount of financial aid for which they would otherwise qualify. That doesn’t seem fair, but don’t blame me. I don’t make the rules.
On the other hand, Roth IRAs – along with other retirement accounts – are not considered assets when determining a family’s EFC. There’s no cap to that amount either, so you may actually be able to accumulate significant sums in Roth IRA and still qualify for student aid for a child.
#2 – Roth IRAs are more Flexible
As noted above, 529 plans are expressly designed for use to pay for qualified higher education expenses, like college tuition. To encourage you to contribute money to such an account, Congress created special tax breaks. As long as 529 plan distributions are used to pay qualified higher education expenses, distributions are 100% tax free (in some states, you may also be entitled to a state income tax deduction). So, for example, if you contribute $5,000 to a 529 plan and it grows to $20,000 by the time your child goes to college, the full $20,000 can be distributed tax and penalty free (provided it’s used to pay qualifying expenses).
That all sounds great – and it is – but if for some reason the funds in the 529 plan are not used for qualifying expenses, distributions can go from being tax free to being quite pricey. In addition to owing income tax on any gains, such distributions are assessed a 10% penalty. True, a 529 plan set up for one child’s benefit can be transferred for the benefit of another qualifying family member, but such a person does not always exist.
For obvious reasons, parents are often encouraged to start saving for college as early as possible. How are you supposed to know for sure though, if your 5-year-old child is going to go to college? Or what if – and I dare to even say it – they get a scholarship? That could turn a tax-efficient account into a tax nightmare. If, instead of saving money in a 529 plan, you saved the same money in a Roth IRA (you could still earmark some or all of it in your own way for education) and no longer needed those funds for education, it’s an easy and tax-efficient transition to use those funds in retirement. If you actually did need to use the funds to pay for a child’s college expenses, the Roth IRA may even provide the same tax-efficiencies as a 529 plan. Which brings us to our third point.
#3 – Roth IRAs May Provide the Same Tax-Free Treatment for Distributions
The primary purpose of contributing funds to a 529 plan is to enjoy tax-free distributions for education purposes, but a Roth IRA often provides the exact same tax benefits. If you are over age 59 ½ at the time you take distributions from your Roth IRA and you’ve had any Roth IRA for five years or longer, then anything you take out of your Roth IRAs will be 100% tax and penalty free. That’s true whether you use the funds for education-related expenses or for any other purpose. With shifts in societal trends and more people waiting to get married and have children, it is increasingly common for education-related expenses to be incurred after the five years/59 ½ requirements are met.
Even if you’re not age 59 ½ (or haven’t met the required holding period) at the time education-related expenses need to be paid, you may still be able to take funds out of your Roth IRA tax and penalty free. Roth IRA contributions can be distributed at any age, and at any time, 100% tax and penalty free. So, for instance, if you contribute $5,000 per year to a Roth IRA for the next 10 years before your child goes to college (and take no distributions in the interim), at the very worst, you’d be able to take $50,000 tax and penalty free from your Roth IRA.
In addition to Roth IRA contributions, amounts converted to a Roth IRA may also be able to be distributed tax and penalty free. Even if you’re under age 59 ½, Roth IRA conversions can be withdrawn tax and penalty free as long as the conversion took place five years ago or longer. So, for example, if you convert $100,000 to a Roth IRA today at age 50 and need to take that $100,000 out in six years to meet education expenses, the entire amount will be tax and penalty free. And, if you wait until you’re age 59 ½, any gains you earned on that $100,000 while it was in your Roth IRA will also be able to come out tax and penalty free. That’s a pretty sweet deal!
So as you can see, there’s more than a few reasons to consider a Roth IRA as a savings vehicle for a child’s education. That said, everybody’s situation is different and you should always evaluate all of your options to see what’s best for you and your family.