How to Use a Roth IRA to Save for College
Roth IRAs have some characteristics that may make them an attractive way of saving for college. But, using a Roth IRA to save for college may backfire, causing reductions in eligibility for need-based financial aid.
A Roth IRA is a retirement plan that was created by the Taxpayer Relief Act of 1997 [P.L. 105-34], effective starting January 1, 1998. Contributions to a Roth IRA are made with after-tax dollars. Contributions are not tax-deductible and do not reduce the taxpayer’s adjusted gross income (AGI). But, distributions are tax-free, under certain conditions, and do not increase AGI or affect Social Security benefits.
Earnings in a Roth IRA may be withdrawn tax-free if the account has been open for five years and if the taxpayer is age 59-1/2 or older or is disabled. Contributions, however, may be withdrawn tax-free after five years, even if the taxpayer has not yet reached age 59-1/2.
The five-year clock starts on January 1 of the year in which the first contribution occurred. The five-year clock resets for conversions from a traditional IRA to a Roth IRA, but otherwise does not restart for subsequent contributions.
Benefits of a Student’s Roth IRA for College Savings
Although intended for retirement savings, a Roth IRA can also be used to save for college. A Roth IRA provides the flexibility to use the money for retirement if the child decides to not go to college or if there is money left over after college graduation.
This will give the student a head start on saving for retirement. Assuming a realistic annual return on investment, the money in a Roth IRA can grow by a factor of 4 to 9 by the time the student retires. Roth IRAs, like other qualified retirement plans, are ignored as assets on the Free Application for Federal Student Aid (FAFSA).
While non-qualified distributions from a Roth IRA are subject to ordinary income taxes plus a 10% tax penalty, the tax penalty is waived if the distribution is used to pay for qualified higher education expenses. Qualified higher education expenses are the same as for 529 college savings plans and include tuition, fees, room and board, books, supplies and special needs expenses. The expenses must be for the education of the taxpayer, spouse, child or grandchild at a college or university that is eligible for Title IV federal student aid.
Flaws with Using a Roth IRA to Save for College
Distributions from a Roth IRA, even a tax-free return of contributions, will count as income on a subsequent FAFSA. Regardless of whether the distribution is included in AGI or counted as untaxed income, it may reduce eligibility for need-based aid by as much as half of the distribution amount.
The mere existence of a Roth IRA will not affect eligibility for need-based aid. However, if the taxpayer uses the money in a Roth IRA to pay for college, it will reduce eligibility for need-based aid in a subsequent year. 529 college savings plans have a much more favorable impact on the expected family contribution (EFC) than a Roth IRA.
There are several other drawbacks with using a Roth IRA to save for college:
- While 35 states offer a state income tax deduction or tax credit on contributions to the 529 plan, no similar benefit is available for contributions to a Roth IRA
- Investments in a Roth IRA may be optimized for retirement (long term) and not for college (near term)
- 529 college savings plans may have lower-cost investment options than a Roth IRA, due to access to institutional share classes that have a lower expense ratio
- As challenging as it is to get friends and family to give the gift of college by contributing to a 529 college savings plan, it is even more difficult to get them to contribute to a Roth IRA
There are no age limits on contributions to a Roth IRA, but there are income limits. A taxpayer is eligible to contribute to a Roth IRA until the taxpayer’s modified AGI reaches $118,000 to $133,000 for single filers and $186,000 to $196,000 for married filing jointly. (These are the 2016 income phrase-outs. The income phase-outs are adjusted for inflation and rounded to the nearest $1,000.) There are no income phase-outs on distributions.
Contributions to a Roth IRA are subject to annual limits. Taxpayers can contribute up to $5,500 a year ($6,500 if the taxpayer is age 50 or older as of December 31 of the tax year) or the earned income, whichever is less. Excess contributions are subject to a 6% excise tax. These limits may restrict the amount of money in a Roth IRA, since children have a limited number of years during which they can contribute to a Roth IRA.
Taxpayers can bypass the contribution limits by contributing to a traditional IRA and converting it to a Roth IRA, although this will reset the five-year clock before tax-free distributions can occur. (A Roth IRA conversion may lead to a tax liability if the Traditional IRA included any pre-tax contributions, which will be included in the conversion pro-rata.)
Workarounds that Avoid the Impact on Financial Aid
If the student will not qualify for need-based financial aid, the focus should be entirely on the tax impact, not the financial aid impact. However, families have a tendency to overestimate eligibility for merit-based aid and to underestimate eligibility for need-based aid. Even dependent students whose parents have a six-figure income may qualify for some need-based financial aid, if there are two or more children in college at the same time or if the student enrolls in a higher-cost college.
With the switch of the FAFSA to using prior-prior year income and tax information, distributions from a Roth IRA after January 1 of the junior year in college will not affect eligibility for need-based aid, assuming that the student will not go on to graduate school within two years of graduating from undergraduate school. Another option is to take a tax-free return of contributions after graduation to pay off student loan debt.
Using a Parent or Grandparent Roth IRA to Save for College
Another possibility is to save for college in a parent’s or grandparent’s Roth IRA. Parents can use Roth IRA distributions to pay for college, especially if they are age 59-1/2 or older. But, given that there are limits to the amounts that can be saved for retirement using a Roth IRA, this is not a good idea if the parent does not also have money in a 401(k) or other retirement plan. Parents should not sacrifice retirement savings for their children’s college education.
Grandparents could plan on having their Roth IRAs inherited by their grandchildren. If the grandchildren are listed as beneficiaries on the Roth IRA, it can bypass probate. Although a Roth IRA does not require minimum annual distributions after age 70-1/2, unlike all other retirement plans, an inherited Roth IRA may be subject to minimum required distributions, typically 1% to 2% per year. While these distributions will be tax-free, they will nevertheless be counted as untaxed income on the FAFSA, reducing eligibility for need-based aid by half of the distribution amount. Still, the distribution amounts are likely to be relatively small.
Note that grandparents must list the grandchildren as beneficiaries on a form provided by the company that manages the Roth IRA, not in their will. Otherwise, the Roth IRA may become part of the grandparent’s estate. Even if the grandchildren are named as beneficiaries in the grandparent’s will, they would not be considered designated beneficiaries. This would require the Roth IRA to be distributed to the grandchildren within five years, yielding a much more severe impact on eligibility for need-based aid.