A Roth IRA For College Savings

Can you use your Roth IRA for college savings?

Absolutely.

While its primary purpose is saving for retirement, you can withdraw your original principal contributions tax-free and penalty-free at any time as well as avoid the 10% early withdrawal penalty by taking an early distribution to pay for "qualified higher education expenses" such as tuition, books, and fees.

According to the IRS, you can take a penalty-free distribution of your Roth IRA investment gains to pay for educational expenses, if...

• You paid qualified higher education expenses
• You paid those expenses to an eligible educational institution, and
• An eligible member of your family incurred the expenses

For more information on what constitutes "qualified higher education expenses" or an "eligible educational institution," read Roth IRA Education Distributions for Educational Expenses.

An Alternative To Traditional College Savings Plans

Because of the favorable tax rules and the available flexibility, using your Roth IRA for college savings is a viable alternative (or supplement) to the more well-known traditional college savings plans, such as...

• Coverdell Education Savings Account
• 529 Plan
• Traditional Brokerage

With a Coverdell ESA, you're limited to a maximum annual contribution of $2,000 versus $5,000 for a Roth IRA ($6,000 if you're over 50).

Depending on the terms of the plan available in your state, a 529 plan is a great way to save for college. But what if you save too much? What if your child doesn't go to school? Under certain plans, you might trigger taxes and penalties if you don't use the money you saved to pay for higher education expenses.

But a Roth IRA?

Just keep the funds where they are and use them in retirement. It's that simple...

A traditional brokerage account is also a method some people use to save for college, but as a non-tax sheltered alternative, it's not very compelling. The tax advantages are far better if you use a Coverdell ESA, a 529 plan, or a Roth IRA for college savings.

Advantages To Paying College Expenses

So what are the advantages of using your Roth IRA for college savings?

Here's a few notable advantages...

• Tax-free, penalty-free withdrawal of original contributions
• Tax-free growth until the time of withdrawal
• Flexibility

Tax-free, penalty-free withdrawal of original contributions - Since you can withdraw your original contributions tax-free and penalty-free at any time for any reason, your Roth IRA doubles as a sort of tax-free savings account.

For instance, let's say you put $2,000 per year into your Roth IRA from the time your first child is born until they reach age 18. That adds up to $36,000 in contributions, and the entire $36,000 can be withdrawn tax-free and penalty-free.

Tax-free growth until the time of withdrawal - Unlike a traditional brokerage account, but similar to most college savings plans, your Roth IRA offers tax-free growth of your principal contributions until you withdraw them.

And while you have to pay income taxes on early distributions from your Roth IRA, you can avoid the 10% early withdrawal penalty if investment gains are withdrawn to pay for "qualified higher education expenses." And given that the Roth IRA ordering rules require original principal contributions to be withdrawn first, you can likely use those to pay for most of your college expenses, thus limiting the amount of funds which are subject to income taxes.

Flexibility - While a number of college savings plans, such as the popular 529 plans, place limits on your investment options, saddle you with higher management fees, and lock you into specific educational options, your Roth IRA offers a wide array of flexibility.

For instance, what happens if you save $50,000 in a 529 plan, but your child never attends college? Or say they only incur $20,000 in tuition expenses at the local community college?

In some cases, if you want access to the funds in your 529 plan, those funds are subject to income taxes and an early withdrawal penalty.

But your Roth IRA?

Just leave the money where it is, and it's waiting for you in retirement.

In the meantime, you control your management fees and decide what to invest in.

Can you see now why using your Roth IRA for college savings might offer a bit of flexibility?

Disadvantages To Paying College Expenses

So what are the disadvantages of using your Roth IRA for college savings?

While there are probably a number of disadvantages, two in particular stand out...

• Subject to income taxes upon withdrawal
• Depletes your retirement savings

Subject to income taxes upon withdrawal - While you can withdraw your principal contributions tax-free and penalty-free at any time for any purpose, your Roth IRA investment gains are subject to income taxes even if they're withdrawn to pay for "qualified higher education expenses."

The Roth IRA education distribution exemption only helps you avoid the 10% early withdrawal penalty on any withdrawn investment gains, but you still owe income taxes. So this is an obvious disadvantage.

For instance, let's say you contribute $25,000 to your Roth IRA in the years leading up to your child's college years. Accounting for investment gains, your Roth IRA is now worth $50,000. If you want to withdraw the entire $50,000 to pay for college, what are the tax implications?

Well, the $25,000 in original principal contributions comes out tax-free and penalty-free, leaving you with $25,000 in investment gains. If you're in a 30% tax bracket, you owe $7,500 in taxes.

So, in this case, you only see $42,500 of the $50,000 you managed to save for college.

Depletes your retirement savings - The most obvious disadvantage of using your Roth IRA for college savings is that doing so depletes your retirement savings.

After all, the IRS limits the dollar amount you can contribute to your Roth IRA in any given year. If you're under 50 years old, the limit is $5,000 per year. Even over the course of 20 years, this only adds up to $100,000. At a number of American universities, this barely covers four years of tuition.

So while your Roth IRA might double as a tax effective college savings vehicle, it might also easily wipe out all of your Roth IRA savings when the higher education bill comes due. So if you choose to use your Roth IRA for this purpose, make sure you find alternative savings vehicles for retirement, such as a defined benefit pension plan, a 401k, rental property, etc. In fact, it's a good idea to do all of that anyway.

Conclusion

If you're looking for alternative methods for funding your child's education expenses, you might want to entertain the idea of using your Roth IRA for college savings.

While there are disadvantages to doing so, such as depleting your own retirement fund, the tax advantages and flexibility available with a Roth IRA account are quite advantageous.

Your original Roth IRA contributions can always be withdrawn tax-free and penalty-free for any reason, and your investment gains are NOT subject to an early withdrawal penalty if used to pay for "qualified higher education expenses."

So if you have a spouse, child, or grandchild you anticipate sending to college at some point in the future, you might want to consider using your Roth IRA as a viable college savings alternative.