Roth IRA: How to Use it For College

The cost of education in America can be burdening. In the last 30 years, the average college cost of a four-year public institution has increased by 213%. In the past decade alone, the cost of education has shot up by 29%, with private college tuition costs rising by 25%. If you have children or grandchildren who want to go to college, there is a good chance you would have thought about how to cover their education expenses. One of the most common ways that people use to save for college fees is a 529 savings plan.

529 plans are state-sponsored, tax-advantaged plans that allow you to invest after-tax money into bonds and stocks and then withdraw the money tax-free to pay for qualified education expenses. According to the College Savings Plan Network, as of mid-2019, there were over 14 million 529 college savings accounts with over $352.4 billion in assets. This proves the popularity of the 529 college savings plan among parents planning to send their kids and grandkids to study beyond high school. However, over the years, the popularity of 529 college savings plans has decreased. In March 2020, the balance of the 529 plan dropped down to a $293 billion mark, which is considerably low. One of the reasons for this is the restriction on using the 529 college savings plan for qualified education expenses only. Alternatively, the rise of other tax-saving accounts, like a Roth IRA (Individual Retirement Account), to cover education costs has further added to the waning of the popularity of the 529 college savings plan.

Over the last few years, a growing proportion of American families has started opting for a Roth IRA for education planning. According to the 2020 Sallie Mae and Ipsos survey, nearly 14% of parents withdrew money from their retirement plans, like a Roth IRA, a 401(k), etc., to pay for college fees and related expenses. In 2015, the number was only 6%. In some cases, parents are increasingly substituting the 529 college savings plan with a Roth IRA because of the freedom and flexibility of use, more investment choices, and several other advantages offered by the latter. However, other parents rely on both – a 529 college savings plan and a Roth IRA – to fund their child’s steeply rising higher education costs.

If you want to consider using Roth IRA for college expenses, you must first understand the different aspects of the account. A financial advisor can help you understand the benefits afforded by Roth IRA as well as how best to make use of the flexibility offered by the plan when it comes to freedom of use and different investment options.

Here is everything you should know about using a Roth IRA for education:                

What is a Roth IRA?

Introduced in 1997, a Roth IRA is an individual retirement account where you contribute after-tax dollars, and your money grows tax-free. Moreover, you get tax-free withdrawals, provided you have held the Roth IRA account for five years and you are 59.5 years or older. Roth IRAs have been a popular retirement vehicle ever since their launch in 1997. This is because a Roth IRA offers several advantages over the traditional IRA and other retirement savings vehicles. However, in recent years, parents have also started using a Roth IRA to support their child’s education expenses.

Features of a Roth IRA

• Income eligibility: You can contribute to a Roth IRA at any age, provided you have earned a taxable income. In addition to this, to be eligible to contribute to a Roth IRA, your Modified Adjusted Gross Income (MAGI) should be under $140,000 for 2021 if you are a single tax-filer. However, if you are married and file taxes jointly with your spouse, your MAGI should be lower than $208,000 for 2021.
• Contribution limits: You can contribute to a Roth IRA for yourself and your spouse, provided you file taxes jointly, and either you or your spouse has earned an income. Earned income refers to salary, wages, commission, bonus, freelance jobs, business profits, assignments, etc. The IRS (Internal Revenue Service) alters the contribution limits from time to time. For 2021, you can contribute up to $6,000 in your Roth IRA. However, if you are above the age of 50, you can contribute up to $7,000. These limits are maximum ceilings for one or a combination of Roth IRA If you make contributions above the IRS-defined limit, you will incur a penalty of 6% until the error is rectified.
• Withdrawal rulesThe money in your Roth IRA account grows tax-free until withdrawn. You can take drawings from your Roth IRA at any time. However, if you withdraw money before the age of 59.5 years or before completing five years from the opening of the account, the IRS will levy a penalty of 10% on the sum withdrawn from the account. Moreover, you will also pay tax on the earnings. However, if you use the Roth IRA withdrawals to cover education expenses (postsecondary) or buy a first home, the IRS might waive off the penalty. If you follow the two withdrawal rules, the money you withdraw from your Roth IRA account is considered tax-free. Also, there is no clause for the minimum required distribution in a Roth IRA. Your funds can grow tax-free in your Roth IRA account during your lifetime.

Can you use a Roth IRA for college costs?

Yes, you can use a Roth IRA for college expenses as the IRS levies no restriction on the usage of funds from a Roth IRA account. Whereas, even though a 529 college savings plan allows you to invest your after-tax dollars and offers you tax-free growth, you can only use the money from the account to pay for qualified education expenses of the named beneficiary. Qualified education expenses include tuition, room rent, course-related equipment, and books. If you withdraw money from your 529 savings plan and use it for non-qualified expenses, the IRS will charge a 10% penalty on the sum withdrawn. In some cases, like scholarships, the IRS may permit you to use the funds for another purpose.

Further, in a Roth IRA, the IRS allows you to take tax-free withdrawals before the age of 59.5 or without meeting the five-year account criteria if you use the money to cover the higher education costs of your child or grandchild. In this case, you will not pay the 10% penalty and will only be liable to pay the income tax charges as applicable on the earnings portions of your withdrawal amount. However, in this case, if you limit the sum withdrawn from your Roth IRA to just the contributions, your distributions become both – tax and penalty-free – when used for higher education expenses.

529 Savings Plan compared to using a Roth IRA for college costs: Which is better?

The 529 college savings plans are an effective way to save for your child’s education costs. These plans are state-sponsored, tax-advantaged plans where you can invest your after-tax dollars for higher education. The growth in this account is tax-deferred. If you begin investing in these plans at an early age, you can comfortably sponsor the education expenses of your child. 529 college savings plans invest your money in different secure bonds and low-cost stocks to generate competitive returns in the long run. But your withdrawals are tax-exempt only if you use the sum for qualified education expenses. However, this mandate does not apply to a Roth IRA withdrawal.

Apart from the withdrawal parameter, here is a detailed categorization of the benefits and drawbacks of using a 529 savings plan compared to using a Roth IRA for college costs:

Advantages of using a 529 plan for college expenses

• The contributions are made from after-tax dollars, and the money in your account grows tax-free.
• You do not pay any tax on withdrawal, provided you use the money for qualified education expenses.
• You can get a partial or full tax deduction or credit if you live in a state that offers income tax advantages for using the state 529 college savings plan.
• There is no income or age limit for a 529 plan. However, each state sets its contribution limits.
• You can avoid the federal gift tax if your annual contribution per beneficiary is below $15,000.
• These plans are easy to manage with limited investment options. You can select a specific mode of investment, contribute regularly, and allow your funds to grow over time.
• The 529 college savings plans generally offer low-cost investment options due to access to institutional share classes, which typically have a low expense ratio.
• The 529 plans do not affect your financial aid. These plans are counted at a 5.64% rate at the time of financial aid eligibility assessment. Moreover, qualified distributions from these accounts are excluded, and hence, they do not appear as income on the FAFSA (Free Application for Federal Student Aid) form. Students applying for financial aid have to report income and assets on FAFSA. Most schools use the FAFSA form to determine aid awards. However, if the 529 college saving plan is owned by anyone other than the parent or the student, the distribution is considered as untaxed income on the FAFSA form. In this case, the distributions are counted at a 20%-50% rate.

Disadvantages of using a 529 plan for college expenses

• Your withdrawals from a 529 plan are tax-free only when the money covers qualified education expenses. You have to use the funds for the intended purpose or pay a penalty of 10% along with income tax on the sum withdrawn.
• You only get limited investment options, which restrict the ability of your money to gather its potential returns. This becomes even more disadvantageous if you are a high-risk investor.
• The returns from a 529 plan might not be sufficient to combat education inflation in the long run, owing to the limited investment returns.

Advantages of using a Roth IRA for college expenses

• You contribute after-tax dollars, and your money grows tax-free.
• You can get tax-free withdrawals for any reason if you are 59.5 years old and your Roth IRA account is at least five years old.
• You can take penalty-free withdrawals from your Roth IRA even before the age of 59.5 or the five-year tenure, provided you use the funds to cover the higher education expenses of your child.
• There is no restriction on the usage of funds. You can use your Roth IRA money to pay for your child’s education or any other need. There is no ceiling in terms of Roth IRA qualified education expenses. The money not spent on education costs can be used to support you during retirement.
• You get a wider variety of investment options in a Roth IRA, allowing you to unleash the full potential of your money and get high returns in the long run.

Disadvantages of using a Roth IRA for college expenses

• The annual contribution limits are low. For 2021, you can only contribute $6,000 or $7,000 if you are 50 years or older. In the long run, the contributions might prove to be insufficient to sponsor college costs of your child.
• You cannot contribute to a Roth IRA if you earn above the income eligibility limit. For 2021, if you are a single tax filer and earn more than $140,000, you are ineligible to contribute to a Roth IRA. Moreover, if you are married and file taxes jointly, your income should be less than $208,000 for 2021 to be eligible for a Roth IRA.
• Unlike 529 plans, there is no state exemption for Roth IRAs.
• Roth IRA money is not considered for financial aid purposes. However, if you make withdrawals from the account, it can impact the financial aid package. Because even though the money is not taxed, distributions from the Roth IRA account are considered as your income. The withdrawal amount gets added to your income on the FAFSA form and tallies at a 20%-50% rate, including the tax-exempt return on contributions, which appears as untaxed income.
• Using Roth IRA for education means reducing your retirement corpus. Due to the contribution limitations, you can only save a specific amount each year. However, if you use a significant sum of your Roth IRA balance to pay for education expenses, you will affect your retirement financial security. This becomes even more critical at a time when Social Security benefits are insufficient to fund retirement expenses.

Using a grandparent’s Roth IRA for education

Another medium of covering Roth IRA college expenses is by making use of the grandparent’s Roth IRA. Grandparents can allow their grandkids to inherit their Roth IRA if the grandkids are listed beneficiaries on a Roth IRA. Moreover, in this case, the inherited Roth IRA will also pass the probate process. There are no annual distributions in a Roth IRA, but an inherited Roth IRA will be subject to minimum required distributions like all other retirement plans. Earlier, the IRS allowed beneficiaries of an inherited Roth IRA to distribute the minimum required distributions over their life expectancy. This facilitated reduction of taxes. However, as per the new IRS rules, non-spousal beneficiaries of an inherited IRA should take minimum required distributions within ten years of the owner’s death. The total distribution should be 100% of the Roth IRA funds. The money withdrawn is not taxable if the inherited Roth IRA is older than five years. But in case of delay in taking the minimum required distributions from a Roth IRA, the IRS will impose a tax penalty of 50% on the amount due.

That said, to use a Roth IRA for college fees, grandparents must list the beneficiary in the form provided by the company that manages the Roth IRA and not in their will. If the grandchild is not in the beneficiary form, the Roth IRA will become a part of the grandparent’s estate. In this case, even if the child is named in the will as a beneficiary, they will not be considered a designated beneficiary, which could cause estate-distribution issues. In such a case, the inherited Roth IRA will have to be distributed to the grandchildren within five years. This could have a significant impact on need-based financial aid eligibility.

Using both a 529 college savings plan and a Roth IRA for college expenses

Overall, both the 529 college savings plan and a Roth IRA have their benefits and drawbacks. This makes choosing one out of the two a bit tricky. But as a parent, you can consider investing in a 529 college savings plan and a Roth IRA if you have the required financial support. In such a case, the advantages of one will compensate for the drawbacks of another. Moreover, you will be able to fund the education expenses without compromising on your retirement financial security. You can use the 529 college savings plan to cover the education costs and then tap your Roth IRA balance to pay for the remaining expenses. The leftover sum in your Roth IRA can stay invested for your retired years.

To summarize

Balancing college expenses and retirement plans can be slightly daunting. However, if you use appropriate accounts with sound withdrawal strategies, you can make use of both a 529 college savings plan and a Roth IRA for your child’s education as well as your retirement. You can also consider engaging with a professional financial advisor to intricately understand the functioning of these accounts to make an optimal college and retirement funding strategy.