A Roth IRA is one of the best ways to save for retirement, as the money in it grows tax-free and, in most cases, withdrawals come before retirement with no tax implications. It can be a particularly good way to save for retirement if you are young and your income is relatively low. If you’re in a low tax bracket, you won’t benefit as much from tax deductions (like for 401(k) or traditional IRA contributions).
But while the primary use of a Roth IRA is for retirement, there are a number of other ways you can withdraw money from your Roth IRA without paying a penalty.
One is for qualified higher education spending. That makes using a Roth IRA to save for college an option to consider.
What is a Roth IRA?
A Roth IRA is an alternative to what is now called a “traditional” IRA. Roth IRAs were founded in 1997 and named after Senator William Roth of Delaware. In a traditional IRA, you can take tax deductions for contributions the year you make them, but you pay taxes when you withdraw the money in retirement.
With a Roth IRA, you reverse that tax calculation — you don’t get a tax deduction when you make the contributions, but your earnings go tax-free. You also don’t pay taxes on money you withdraw during your retirement. This combination makes it an attractive way to save for retirement, as you can potentially save unlimited tax-free pension.
Rules for Withdrawing from a Roth IRA
As you might imagine, since a Roth IRA is primarily a means of saving for retirement, there are rules for when and how you withdraw money from your Roth IRA account. Because you make after-tax contributions to a Roth IRA, there is no penalty or tax consequence if you withdraw the contributions. You can always withdraw your contributions at any time. But except in certain circumstances that we will discuss below, if you withdraw any income from your Roth IRA before retirement, you will pay tax and/or a penalty.
In general, you can make a qualifying withdrawal of income from your Roth IRA if you have had the account for at least five years and you are at least 59 ½ years old. There are also some exceptions to this rule, for example if you die, are permanently disabled or use the money to buy your first home.
If you make an unqualified income withdrawal from your Roth IRA account, you will be taxed on the amount of your earnings as ordinary income AND pay a 10% penalty. However, there are a few exceptions that do not require the 10% penalty. Per IRS topic 557, here are some of the most important:
If you withdraw income from your Roth IRA account in any of these categories, you will not incur a 10% penalty (but you will still pay tax on the amount of your income).
Since we’re talking about using a Roth IRA to save for college, let’s look specifically at higher education spending.
As an example, let’s say you made $25,000 in contributions to your Roth IRA and the balance has now grown to $35,000. If you want to withdraw the full amount to pay for qualified higher education expenses, you will not pay any tax or penalty on your $25,000 in contributions. Because higher education is a permissible reason to withdraw earnings before retirement, you will not pay a penalty, but you will pay tax on the $10,000 in earnings.
How Roth IRA Withdrawals Affect Your FAFSA?
The FAFSA is the free application for student aid. It is used to determine whether a student is eligible for student finance.
While a Roth IRA offers great benefits when paying for education, there are a few things to keep in mind to further maximize its benefits.
Withdrawals from a Roth IRA can affect your FAFSA, reducing the amount of financial aid you may receive.
Rick Wilder, the director of financial affairs for students at the University of Florida, states, “Students applying for need-based financial aid are required to report income and wealth information to the FAFSA.”
Retirement accounts are not counted as assets on the FAFSA (so you don’t need to report the balance of your Roth IRA). However, withdrawals from a retirement account, such as a Roth IRA, are settled against the FAFSA.
Planning ahead a bit and possibly even talking to an accountant can help you get the most out of the FAFSA and your Roth IRA for educational expenses.
Cons of Using a Roth IRA for College Savings
While a Roth IRA may be an option to consider when saving for college, there are a few drawbacks to using a Roth IRA for college savings. These drawbacks vary depending on whether you’re withdrawing money from the student’s IRA or a parent’s IRA.
Using a student’s Roth IRA
There are two major drawbacks to using a student’s Roth IRA.
First, it is very difficult to get money for a child’s Roth IRA. There are many rules about earned income, and when kids are young, it’s hard to fund (or fully fund a Roth IRA). If kids start working when they’re teenagers, it’s easier, but even then, the amount you can contribute is probably low.
Second, when you use the money from the account, it counts in full as income for the child. So you may receive benefits for a student entering first year of college, but when completing the FAFSA for their second year of school, they will be required to fully report any amount withdrawn from the previous year as income.
Using a parent’s Roth IRA
Aside from the FAFSA implications, the major downside to using a Roth IRA for tuition is that you’re withdrawing from a retirement account “mid-life.” Do you think you will make up for the loss over time as you are limited in how much you can contribute? It’s hard to say.
For example, let’s say you now start saving the maximum of $6,000 per year and continue for 18 years. Maybe that’s grown to $150,000 in total. That is amazing. But if you start withdrawing $25,000 a year for 4 years, you are now back at $50,000.
Don’t get me wrong, $50,000 for a 22-year-old is great – but what’s the lost opportunity cost of that extra $100,000?
In 40 years, that $100,000 could have grown to $2,172,000 — tax-free. And that without extra contributions! If you take that original IRA and continue adding $5,500 a year, you’ll get $4,682,000 at age 62!
If you start with the remaining amount of more than $50,000 and contribute $6,000 per year, you will now grow to $2,500,000. Not a bad return, but you may end up losing 50% of your value.
That’s the big drawback. Taking money out of a tax-sheltered account, such as a Roth IRA “mid life” or “early life” really hinders future returns on that money. And that would be tax-free money.
529 plans have no contribution limit (other than the gift tax exclusion), but Coverdell accounts have a contribution limit of $2,000 per beneficiary. In general, you have a wider range of investment options with a Coverdell account. Many states offer tax credits or tax deductions for contributing to a 529 planCoverdell accounts have a broader list of what counts as an educational expenseCoverdell accounts also have limits on contributor income and beneficiary age
In either case, you can use tax-free distributions to pay for qualified educational expenses. Instead of using a Roth IRA for college savings, consider one of these types of accounts.
Many people want to use a Roth IRA to save for college because they think “what if my kid doesn’t go to college — that money could be wasted”. And while that’s a concern, there are still ways to access funds in accounts like a 529 plan or Coverdell.
While you can use a Roth IRA to save for college, the downsides outweigh the rewards in our opinion.
The first is that you may have to pay taxes on any income you withdraw. It can also affect your FAFSA and the amount of financial aid your student may be eligible for. But the biggest downside is how it can negatively impact your own retirement savings.
Remember that you can always get financial aid to pay for your studies, but there is no financial aid to pay for your retirement!
Rather than using your Roth IRA, most people will be better off with a 529 plan or Coverdell Education savings account to pay for college.
Would you consider using Roth IRA funds for high education costs? Why or why not?
This post Roth IRA to save the university
was original published at “https://thecollegeinvestor.com/21215/roth-ira-save-for-college/”