Can You use a Roth IRA to Save for College?

Education

Posted on February 15th, 2024

We usually like to start our blogs with a little more pizazz or maybe even an entertaining anecdote, but we don't want to be accused of doing the ol' bait and switch, so buckle up we're going straight into the weeds about the merits of saving for college with a 529 versus a Roth IRA. If that sounds like your cup of tea, you're in the right place.

We're comparing the two side by side to see which is the better option. Spoiler alert: it's a 529 plan. 529 plans and Roth IRAs both grow tax-free, but IRAs have some limitations when it comes to using them for college. As much as we wish there was a hack to college savings, a Roth IRA isn't it.

TL;DR Save for college the smart way

Financial Aid

Your expected family contribution (EFC) is the amount the federal government determines your family can reasonably spend on college tuition, and is calculated from the information entered in your Free Application for Federal Student Aid (FAFSA). Your EFC determines the amount and type of aid that a child will receive to attend college. This number can be affected by your assets, including savings and investment accounts.

Roth IRAs: While funds are in a Roth IRA, they are not reported on the FAFSA and do not affect your EFC. But once the funds are withdrawn, they are reported on FAFSA as income, negatively affecting your kids' EFC. Your student's aid package can be reduced by up to 47% of the funds withdrawn from your Roth IRA when they are reported on your FAFSA. That means, if you withdraw $10,000 from your Roth IRA to use towards college expenses, your need based eligibility would be reduced by up to $4,700! It's also important to keep in mind that some schools will ask for more financial information than just your FAFSA when considering aid packages, and a Roth IRA could be considered.

529 Plans: 529 plans have the least impact on financial aid eligibility of any savings method. Because 529 plans are built for college savings, the impact it can have on your EFC is capped at 5.64%. For example, if the parent is the account owner, and you save $10,000 in a 529 plan, your need based eligibility would only be reduced by a maximum of $564, but likely less.

Income Limits

Roth IRAs: Another important consideration is the strict income limit on contributions to a Roth IRA. The amount you can contribute (from $0-$6,000 annually) to a Roth IRA is determined by your Modified Adjusted Gross Income (MAGI). Your household's MAGI is your household's adjusted gross income plus tax-exempt interest income and certain deductions. You can calculate your household's exact MAGI here.

See how much you can contribute here:

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This matters for two reasons. First, even if your MAGI is below the threshold now, if you expect to earn more than the contribution cutoff at some point, a Roth IRA will not be a good long term plan for college savings. Eventually you will lose the ability to contribute to this plan, and this can limit your ability to save enough to cover the cost of education. Second, you are only able to contribute $6,500 annually.

If you are planning on using this tax-advantaged account for your retirement as well, you likely won't be able to save enough to cover both.

529 Plans: A 529 plan has no income limit restrictions, but plans do have a limit on the balance. The limits vary by state, but most states' maximum balance ranges from $350,000 to $500,000. Once your account has reached the maximum balance, you will not be able to add any more contributions, but the money that's in the account can keep growing without any penalty. Keep in mind that you can open a different plan for each of your children, and if you want to exceed your state's balance limit for a single plan, you can open another plan in a different state. When opening a 529 plan, you are not required to use your home state's 529 plan, so consider the balance limits when deciding which state's plan is the right fit for your goals.

There is also a gift feature, allowing a parent or grandparent to each contribute up to $15,000 ($30,000 for married couples) a year to a 529 plan while qualifying for gift tax exclusion. If you're one of the fortunate few, or you win the lottery, it is possible to superfund up to $75,000 ($150,000 for married couples) in one year to maximize your compounding returns, but then you can't touch the money for five years. The gift tax exclusion is for $15,000 per person, so you can still accept contributions from your aunts, uncles, friends, and more, even if a parent or grandparent or both have maxed out the gift tax exclusion for that year. Plus, most states tax deductions apply no matter what your income is. You can maximize your tax-advantaged accounts by using a 529 plan for college and a Roth IRA for retirement.

Penalties

Because these accounts are designed to help you save for a specific goal, there are penalties when they are used for other purposes.

Roth IRAs: Roth IRAs have a strict set of rules for withdrawals. You are allowed to withdraw contributions you made to a Roth IRA at any time without a penalty. However, you will have to pay penalties and taxes on earnings if you take a distribution from the account before you reach retirement age (59 1/2). There are some exceptions depending on how long you have had your account.

If you have had the account under 5 years and are under 59 1/2, you will still have to pay the taxes when withdrawing funds for qualified situations, but you can avoid the 10% penalty. If the account is over 5 years old and you are making a withdrawal before you turn 59 1/2, you can avoid the taxes and the penalty. You can avoid either the penalty or the penalty and taxes (depending on the age of the account) in these situations:

Qualified education expenses
Unreimbursed medical bills
Health insurance if you are unemployed
First-time home purchase (up to $10,000 lifetime limit)
Bills due to a disability
Qualified childbirth or adoption expenses

When taking a distribution before you turn 59 1/2 it is crucial to confirm that any expense you plan to cover with the withdrawal is qualified. It is also useful to open the plan more than five years before you plan on using withdrawals to fund your child's education so you can avoid owing taxes.

529 Plans: If you withdraw funds from a 529 plan for anything other than education expenses, you will owe taxes and a 10% penalty on only the investment gains/earnings of the account. You will not have to pay anything taxes or penalties on the funds deposited into the plan. The good news is that education expenses can include tuition, fees, room and board, books, computers, food, and even study abroad programs.

If your child gets a scholarship, you can withdraw the amount equal to the scholarship without incurring the 10% penalty. You will still owe income taxes on the earnings, but never on the deposit. If for any other reason you don't need the money for college you can transfer the account to a new beneficiary without tax consequences.

Other Considerations

Will college become free? There are a lot of theories about changes in education policy over the next few years. 529 plans have changed over time inline with changing fiscal policy, and we expect that they'll keep doing the same. If college does become free, there will likely still be costs associated with education, such as textbooks, fees, room and board, meal plans, and other expenses to compensate for lost revenue from tuition.

It's also important to keep in mind that, if necessary, you can take out a loan to pay for college. You can't take out a loan for retirement.

It's important to protect your nest egg so when it comes time to retire, you are financially prepared to do so. Plus, your retirement fund can also benefit your kids. If you save effectively for your retirement, then it's less likely that your kids will have to support you in your old age.

No one else can contribute to your IRA, but you can get help from friends and family with a 529 plan.

Plus, it's a lot less weird to ask for a contribution to your child's education than toward that timeshare in Boca. And with Raise Education, loved ones can easily contribute to your plan with a credit or debit card. It's a great way to avoid receiving 5 copies of 'Goodnight Moon'.

At the end of the day, we recommend using the right tool for the job. Sure, we have all used our sleeve as a burp cloth, but it's nice not to have to. If you think you may have educational expenses on your horizon, 529 plan is an effective way to save for college. A Roth IRA is a great way to save for retirement. There's no reason you can't have both. In fact, having both plans gives you the best of both worlds. If you don’t use all the funds in your 529 Plan for educational expenses, you can always rollover the balance into a Roth IRA to keep the tax advantages going. We speak more about rolling 529s into Roth IRAs here.

Set up a 529 plan in less than 5 minutes!

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