How to Tap into a Roth IRA for College Savings & Education

graduation student moneyIf you have children at home who hope to go to college someday (or someday soon), it’s important to plan ahead financially. College tuition is increasing every year and financial aid is never as generous as one could hope.

You might already be familiar with 529 college savings plans, but you can also take advantage of another way to save for college – your Roth IRA. While it won’t generally be suitable as your only method, it can offer several advantages.

Reasons to Use a Roth IRA for College Savings

  1. Unlike a 529 plan, if your child doesn’t end up needing the money for college, you won’t incur a penalty to use it for something else. If you want to withdraw money from a 529 to use for a non-education related expense, you’ll be charged a 10% penalty.
  2. You can withdraw your Roth IRA contributions at any time without penalty or tax for any reason. You can also withdraw earnings without the 10% penalty if they’ll be used to pay for qualified education expenses. You will have to pay tax on those earnings if you choose to withdraw them, so you may want to leave them in the account for your own retirement. Roth IRA earnings are only tax-free if withdrawn after 59 1/2, even if used for education expenses (i.e. tax implications of retirement accounts).
  3. If you contribute to a Roth IRA and qualify for the Saver’s Credit, you could get a break on your taxes. On the other hand, contributions to a 529 plan or other college savings plans are not eligible for this credit.
  4. It’s important to consider the effect your savings will have on your child’s eligibility for financial aid. In general, parental ownership of and withdrawals from a Roth IRA will have no impact, or minimal impact, on financial aid eligibility. 529 plans, however, regardless of ownership, will negatively affect financial aid eligibility. Who owns the 529 plan determines how extensive the impact is.

Roth IRA vs. 529 College Savings Plan

Most individuals won’t be able to fully fund their child’s college expenses with a Roth IRA because of the maximum IRA contribution limits: $5,000 annually ($6,000 if you’re 50 and older). A 529 can be a great complement to saving with a Roth IRA. However, there are a few caveats to be aware of.

Remember, a 529 can affect financial aid, while a Roth IRA typically does not.

  • If your child is an independent student and is listed as both the owner and beneficiary of their 529, it will be counted as their asset and seriously detriment their ability to qualify for aid. If a 529 plan is held as a parent asset, it also affects financial aid eligibility, but to a lesser extent. A 529 plan owned by someone other than the parent or student is not reportable at all on the FAFSA, but distributions from such a plan are counted as student income, which can make it extremely difficult to qualify for aid.
  • On the other hand, Roth IRAs are not counted among parental assets on the FAFSA and if you withdraw contributions, they won’t be counted as income either. A parent-owned Roth IRA and withdrawal of only contributions will have zero effect on financial aid eligibility. If earnings are withdrawn, however, they will be reported as parent income and probably have a minor effect. Students should NOT own significant amounts in Roth IRAs because that will count as a student asset and make it much harder to get financial aid.

Contributions to a Roth or a 529 are not tax deductible (except at the state level for some 529 plans), though by contributing to a Roth IRA, you may qualify to earn the Saver’s Credit.

  • If you can save less than $5,000 a year, Roth contributions alone may be your best bet ($10,000 if both parents are saving).
  • However, if you’re able to save above this amount, complement the Roth IRA with a 529 plan. The benefit to the 529 is you don’t need to worry about contribution limits so much as you need to worry about gift tax. After you give $13,000 to a particular beneficiary in one year, taxes may be payable on the excess amount. So while a Roth IRA affects financial aid less, if you’re able to save more money, contribute the maximum to the Roth IRA and any excess to a 529 plan.

piggy bank education paid

Contributions, Earnings, and the 5-Year Rule

There is a rule regarding the withdrawal of earnings from a Roth IRA known as the five-year rule. It basically states that the account must be open and funded for five tax years before earnings can be withdrawn for a qualified purpose without a 10% penalty and potentially tax-free. Education expense is a qualified purpose, and still subject to the five-year rule.

Remember, contributions can be withdrawn at any time. If you withdraw Roth earnings for educational purposes, make sure the account has been open with money in it for at least five years. You will be taxed on the earnings withdrawal, but not assessed a penalty.

As an example, consider an example with a father named Dan. He’s contributed $2,000 to his Roth IRA every year since his daughter Sarah was born. Now that Sarah is 18, Dan’s Roth IRA holds $36,000 in contributions and its total value is $68,000. Dan can withdraw up to $36,000 without taxes or penalties at any time for any reason, including to pay for Sarah’s college education. This money won’t be counted as income for Sarah’s FAFSA application. If he withdraws more than the amount he contributed, it’ll be taxed. But he won’t get hit with the 10% penalty because he’s held the account for more than five years and is using the money to pay for college. However, he will have to report the earnings withdrawn as his income on Sarah’s FAFSA.

Using a Traditional IRA for College Expenses

If you have a traditional IRA, you’ll owe income tax on any money that you withdraw at any time. Like the Roth IRA, the 10% penalty is waived if you use the money for educational purposes. However, since the tax bill on withdrawals from a traditional IRA can be pretty steep, I wouldn’t recommend planning to use one to save for college. The ability to withdraw Roth contributions tax-free is what makes them a good option for college savings.

Also, when you withdraw money from a traditional IRA and have to pay taxes on it, it gets added to parental assets as income on the FAFSA. That might end up costing you a lot in financial aid, since to the school it would look like you just had a great year!

Final Word

While a Roth IRA can be an excellent college savings vehicle, contributions need to be balanced with your own retirement savings. If you are using a Roth to save for college for your children, make sure you’re also saving for yourself. This could be in a work-sponsored 401k retirement plan or also in a Roth that’s doubling as a college savings vehicle.

Examine the advantages of using a Roth IRA for retirement savings and compare these with the advantages of using one for college savings. Consider what other retirement plans are available to you, how you feel about tax-free vs. taxable income at retirement, and how much you can annually contribute. You may end up choosing the 529 over the Roth to save for college, in spite of the Roth’s college savings advantages.

As with most financial planning, the process must be personalized to your unique situation. Preparation is key. You may want to meet with a financial advisor in order to put together a comprehensive and customized plan.

How are you planning to pay for your child’s higher education?

  • John

    Withdrawals from Roth ARE COUNTED as FAFSA income, which can greatly influence the financial aid eligibility. If you are relying on financial aid and planning to tap Roth for the college costs, you need to plan the withdrawal timing very carefully.

    • TaxDude

      You are correct, this article is leading readers to incorrect conclusions. Withdrawals from ROth ARE COUNTED even though they are withdrawals of contributions….

    • brent

      What would be the best timing?

  • rbharol

    Should I close my Kid’s 529 accounts (They don’t have much in there anyways) and move the money to my wife’s Roth IRA?

    • Kira Botkin

      If you withdraw money from a 529 account and don’t use it for education, you’ll owe penalties. You could put any future savings in the Roth though.

      • rbharol

        Kira, Thanks for answering my question. My 529 does not have much in gains Just 1000 dollars of appreciation since I put money in. so penalty is not much in terms of dollar amount. My concern is inability to get the grants later. Should I just bailout of 529 and move money under roth?

        • Kira Botkin

          You will pay a 10% penalty on the withdrawal, pay income taxes on the growth, and have to repay any state tax breaks you got on the money. So if that is worth it to you, then putting it in the Roth is a smart thing to do. Just make sure that you are saving enough for your and your wife’s own retirement elsewhere!

  • Dan

    Do I need any special paper work to withdraw from my Roth to pay for my sons college

  • papasmurf

    It would really help if there was a date on this article. This would give context to the laws at the current time of writing.

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