Can I Use A Roth IRA to Pay for College?

It is no secret that the cost of education in the US is extremely high. Over the last three decades, the average cost of tuition in a four-year public institution has increased by 213%. If we talk about the past decade only, the average college cost has shot up by 29% with private college tuition costs not far behind having increased by a whopping 25%. Due to the rising cost of education, it would be prudent if you have given thought to how you would want to cover the education cost of your children or grandchildren in the future. A 529 plan is one of the most popular ways by which you can save for college tuition.

A 529 plan is a state-sponsored, tax-advantaged plan wherein you can invest your after-tax money into bonds and stocks to later withdraw at a later date to pay for qualified education expenses. As per the College Savings Plan Network, there were more than 14 million 529 college savings accounts having an asset value of over $352.4 billion as of mid-2019.

However, the popularity of the 529 college plan has declined over the past year or so, as its asset value dropped to $293 billion in March 2020. This is significantly low. Being able to use a 529 college savings plan fund for qualified education expenses only, coupled with an increase in popularity of Roth IRA (a tax-advantaged, tax-saving account which you can use to pay for education costs), has contributed to a fall in the popularity of the 529 college savings plan.

This is backed by numbers from the 2020 survey which revealed that almost 14% of parents took money out from their retirement plans, like a Roth IRA, a 401(k), etc., to cover college fees and related expenses. This number was only 6% back in 2015. There has been a sustained increase in parents switching to a Roth IRA from a 529 plan due to several factors such as freedom and flexibility of use, a higher number of investment choices, etc. However, some parents choose to invest in both - a 529 plan and a Roth IRA to finance their child’s college tuition.

If you wish to use your Roth IRA for college expenses, it is advised to first consult with a financial advisor to understand the benefits afforded by Roth IRA and how you can best utilize the flexibility offered by the plan when it comes to a wider choice of investment options.

What is a Roth IRA?

To put it simply, a Roth IRA is a tax-advantaged individual retirement account where you contribute after-tax dollars, and your money grows tax-free. Herein, you can make tax-free withdrawals if you have fulfilled the following requirements: completed a 5 year holding period and reached the age of 59.5 years or above.

Let us discuss some of the key points of a Roth IRA:

  • Income eligibility: You can contribute to a Roth IRA irrespective of your age provided you earn a taxable income. In 2022, as a single taxpayer, your Modified Adjusted Gross Income (MAGI) should be under $144,000 to be eligible to contribute to a Roth IRA. For married taxpayers, their MAGI should be less than $214,000.

  • Contribution limits: You or your spouse can contribute to a Roth IRA provided either you or your spouse has earned a taxable income in the previous year. For 2022, you can contribute up to $6,000 in your Roth IRA which can be bumped up by a catch-up contribution of an additional $1,000 if you are above the age of 50, taking your total contribution for the year to $7,000.

  • Withdrawal rules: As stated above, you can make tax-free withdrawals after holding a Roth IRA account for more than five years and having reached 59.5 years of age. You can withdraw your funds at any time but a penalty of 10% would be levied on the sum withdrawn by you. The IRS may waive off the penalty if you use the withdrawn funds for qualified expenses such as the first-time purchase of a home or for postsecondary education expenses.

Can a Roth IRA be used to pay for college tuition?

Yes, you can use your Roth IRA funds for college expenses since there are no restrictions placed on their use. Moreover, you can withdraw funds without incurring a penalty if you are going to use the money to cover the higher education costs of your child or grandchild. However, you would have to pay income tax charges on your earnings portion of the withdrawn funds. But there is a workaround to avoid paying the tax. If you limit the sum withdrawn from your Roth IRA to just the contributions, your Roth IRA distribution becomes both – tax and penalty-free – when used for college tuition.

529 Plan vs Roth IRA: Which is better for covering higher education expenses?

Let us go through the pros and cons of 529 plans when it comes to saving for college tuition.

Advantages of investing in a 529 plan for college expenses:

  • Contributions are made from after-tax dollars and the deposited money can grow on a tax-free basis.
  • You can make tax-free withdrawals provided you use the withdrawn funds for education expenses.
  • You can apply for a partial or full tax deduction or credit if you reside in a tax-friendly state that offers tax breaks for using the state 529 college savings plan.
  • No specific income or age limit however each state sets its own contribution limits.
  • If you contribute less than $15,000 per beneficiary each year, you can avoid paying the federal gift tax.
  • Easy to manage since you have access to limited investment options as you can simply choose a specific mode of investment, make regular contributions, and allow your funds to grow over time.
  • 529 plans do not affect your ability to apply for or receive financial aid. Counted at a rate of 5.64% at the time of financial aid eligibility assessment, any qualified distribution from a 529 plan is excluded, thereby, not shown as income on your FAFSA (Free Application for Federal Student Aid) form. Any student who applies for financial aid needs to reveal their income and any assets they hold on FAFSA. FAFA is used by a majority of schools to award financial aid. Additionally, if the 529 plan is owned by anyone other than the parent or the student, any distribution is treated as untaxed income on the FAFSA form. This makes all distributions subject to a tax of 20%-50%.

Disadvantages of investing in a 529 plan for college expenses:

  • You can make tax-free withdrawals from a 529 plan only if they are for qualified education expenses. The withdrawn funds can only be used for paying – enrollment fees, tuition, certain room and board expenses (on campus), certain rent, food and utility bills (off-campus), computers, software, Internet access, and fees, books, supplies, and equipment for participation in a registered and certified apprenticeship program. If the funds are not used for qualified education expenses, then you would have to pay a penalty of 10% along with income tax on the sum withdrawn.
  • You have access to limited investment choices that limits your ability to gain potential returns exacerbating the situation if you are a high-risk investor.
  • Your 529 plan returns may not be enough to tackle education inflation due to insufficient investment returns.

Advantages of investing in a Roth IRA for college expenses:

  • Since you contribute after-tax dollars, your money can grow on a tax-free basis.
  • You can make tax-free withdrawals for any given reason provided you have completed a 5 year holding period and have reached 59.5 years of age.
  • You can make penalty-free withdrawals even without satisfying the aforesaid conditions provided you use the funds to pay the college education costs of your child.
  • Access to a wider range of investment choices allows you to generate higher potential returns in the long run.

Disadvantages of investing in a Roth IRA for college expenses:

  • Low annual contributions limits set by the IRS. For 2022, an investor can contribute only $6,000 or an additional $1,000 if he/she is above 50 years of age. The contributions may prove to be insufficient to sponsor the college expenses of your child in the future.
  • You cannot contribute if you do not meet the income eligibility limit for a Roth IRA. For 2022, if your MAGI is more than $144,000 as a single taxpayer, you are ineligible to contribute to a Roth IRA. If you are a married taxpayer or file taxes jointly, your income should not exceed $214,000 to be eligible for a Roth IRA.
  • No state exemption is afforded to Roth IRAs, unlike 529 plans.
  • Even though withdrawn funds from a Roth IRA are not taken into account for financial aid purposes, it can have a bearing on your financial aid package. How? Even though the money withdrawn from a Roth IRA is not taxed, the distributions are treated as your income. These distributions are added to your income on the FAFSA form and are shown as untaxed income.
  • If you use your Roth IRA funds to pay for your child’s college tuition, you end up reducing your retirement corpus. Since a Roth IRA has low contribution limits, you can only save a certain specific amount each year. If you end up using a significant chunk on paying for college costs, you would end up hurting your retirement financial security. This is a critical point especially when Social Security benefits are insufficient to fund retirement expenses.

Can you use a grandparent’s Roth IRA for education expenses?

To answer the question, yes, you can use a grandparent’s Roth IRA to pay for college expenses. Grandparents can pass on their Roth IRA to their grandchild as an inheritance provided the grandchild is listed as a beneficiary on their Roth IRA. In addition, by doing so, the inherited Roth IRA can also clear the probate process. Do note that an inherited Roth IRA will be subject to minimum required distributions. As per rules set by the IRS, non-spousal beneficiaries of an inherited IRA must take required minimum distributions (RMDs) within ten years of the owner’s death. Moreover, the total distribution must be the full amount i.e. 100% of the Roth IRA funds. Any funds withdrawn from the inherited Roth IRA will not be taxed if the account is older than five years. However, if you delay taking out RMDs, the IRS will impose a tax penalty of 50% on the amount due.

Further, to use a Roth IRA for college tuition, the grandparent must list the beneficiary in their Roth IRA rather than their will. If the grandchild is not in the beneficiary form, the Roth IRA would be transferred to the grandparent’s estate. If this occurs, then even if the child is named in the will as a beneficiary, the child will not be considered a designated beneficiary. This may result in estate-distribution issues in the future.

Can you use both a 529 college savings plan and a Roth IRA for college expenses?

Both the 529 plan and Roth IRA have their pros and cons. It can be a little tricky to choose one over the other. However, if you have the necessary financial strength to invest in both options, then you should consider doing so. By doing so, the advantages of one plan would compensate for the drawbacks of the other. Additionally, you would be able to take care of your child’s education expenses without jeopardizing your retirement financial security. You may use the funds invested in your 529 plan to pay for college tuition and if needed, can then tap your Roth IRA balance to pay for the remaining expenses. The remainder of the sum in your Roth IRA can stay invested to fund your golden years.

To summarize

Trying to save for retirement while also saving for your child’s college expenses can be a trying experience for most. However, if you combine sound withdrawal strategies along with the right plans, you can do both. You may also look into engaging the services of a professional financial advisor to gain an in-depth understanding of both these accounts – a 529 college savings plan and a Roth IRA – to create an optimal college and retirement funding strategy.

Find highly qualified and vetted financial advisors by answering a few questions about yourself on the free advisor match platform. The free match service matches you with 1-3 fiduciary financial advisors that are suited to meet your financial requirements.

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